and on Funds Rate Overshooting
The minutes of the March FOMC meeting revealed a Committee that is very comfortable with the current state of the economy and with the expected trajectory of both the economy and monetary policy. There seems to be less disagreement among FOMC participants than there has been for some time. “All” participants saw “some further” tightening as likely warranted, while “almost all” wanted to continue the gradual approach.
Little concern was expressed by FOMC participants about the apparent slowdown in spending in Q1: “they expected that the first-quarter softness would be transitory, pointing to a variety of factors.” We are of the same view but would have expected some expressions of caution. Fiscal policy changes were expected to provide a “significant boost” to output. But the uncertainty about the size and timing of those effects suggests that the FOMC will await more concrete evidence of those effects, instead of acting preemptively in anticipation of a large fiscal boost to activity.
The minutes revealed much greater confidence among participants about the return of inflation to 2 percent: “Most participants commented that the stronger economic outlook and the somewhat higher inflation readings in recent months had increased the likelihood of progress toward the Committee’s 2 percent inflation objective.” Policymakers appeared much more confident in the long-held belief that the 2017 inflation slowdown was transitory and so the FOMC should look through the temporary deviation. The anxiety among some FOMC participants about too-low inflation or a drop in inflation expectations has been greatly reduced. The focus of the Committee has now shifted to how best to respond should inflation overshoot its objective, as is now widely expected. Indeed, the March SEP indicated that no participants expected 2020 core PCE inflation to be under the 2 percent objective and no participants saw the risks to their inflation projections weighted to the downside any longer. We were somewhat surprised that, given the stronger inflation outlook, more concern wasn’t expressed by more hawkish policymakers about the risks of overheating.
We know from the macro projections as well as participants’ public remarks that many policymakers expect inflation to overshoot its 2 percent objective under “appropriate” monetary policy. The minutes did describe some discussion of the topic, including this line referring to the inflation doves: “A few participants suggested that a modest inflation overshoot might help push up longer-term inflation expectations and anchor them at a level consistent with the Committee’s 2 percent inflation objective.” Subsequent lines suggest that other participants see both upsides and downsides to an overshoot (italics our emphasis): “A number of participants offered their views on the potential benefits and costs associated with an economy operating well above potential for a prolonged period while inflation remained low. On the one hand, the associated tightness in the labor market might help speed the return of inflation to the Committee’s 2 percent goal and induce a further increase in labor force participation; on the other hand, an overheated economy could result in significant inflation pressures or lead to financial instability.” This statement refers to a situation when output is above potential but inflation remains low. Characterizing inflation as “low” is usually reserved for circumstances when inflation is persistently below 2%. That no longer appears to be a likely outcome. So this strikes us as an especially muddled passage.
As we knew from the macro projections and dots, “A number of participants indicated that the stronger outlook for economic activity, along with their increased confidence that inflation would return to 2 percent over the medium term, implied that the appropriate path for the federal funds rate over the next few years would likely be slightly steeper than they had previously expected.” Participants also discussed the prospect of a funds rate overshoot: “Several participants expressed the judgment that it would likely become appropriate at some point for the Committee to set the federal funds rate above its longer-run normal value for a time.” Separately, the SEP noted that “Nearly all participants projected that it would likely be appropriate for the federal funds rate to rise above their individual longer-run estimates at some point over the forecast period.” The discussion of overshooting the neutral rate included possible communication issues: “Some participants suggested that, at some point, it might become necessary to revise statement language to acknowledge that…monetary policy eventually would likely gradually move from an accommodative stance to being a neutral or restraining factor for economic activity.” But the subsequent sentence suggested that the overshooting issue is an area where the FOMC has no clear consensus yet: “However, participants expressed a range of views on the amount of policy tightening that would likely be required over the medium term to achieve the Committee’s goals.” That’s consistent with the narrative in the SEP, which described the “notable reduction” in the dispersion of dots for 2018 while noting that the ranges for subsequent years had widened relative to the December SEP.
We found it interesting that there were a couple of places in the SEP in which “financial imbalances” were mentioned as a risk of an economy operating above potential. Policymakers have long pointed to financial stability risks as a reason to normalize policy, but generally, the risk has been associated with the potentially deleterious effects of ultra-accommodative financial conditions. Here the SEP cited “the possibility that inflation pressures and financial imbalances could build if economic activity were to run well above its long-run sustainable level.” The concern is related to the risks associated with the cyclical state of the economy, not accommodative monetary policy per se. Governor Brainard raised this concern in her speech on financial stability issues last week.
The minutes suggested that tariff and potential trade wars are on their radar screen, but not front and center just yet: “Participants did not see the steel and aluminum tariffs, by themselves, as likely to have a significant effect on the national economic outlook, but a strong majority of participants viewed the prospect of retaliatory trade actions by other countries, as well as other issues and uncertainties associated with trade policies, as downside risks for the U.S. economy.” As Powell related in his press briefing, “A number of participants reported concern among their business contacts about the possible ramifications of the recent imposition of tariffs on imported steel and aluminum.” It was noted that “Contacts in the agricultural sector reported feeling particularly vulnerable to retaliation.”