An FOMC Undeterred

The minutes of the May FOMC meeting broadly reinforced the message conveyed by the postmeeting statement: This is a committee that is willing to look through the softness in the incoming data on spending and the labor market and that is on track to raise rates “soon” should subsequent readings on the economy confirm that the earlier weakness was transitory. As we anticipated, the drop in core PCE prices in March caught their attention, but again most participants were comfortable with the view that the sag in inflation was transitory. All in all, we see no reason to back off our call for rate hikes in both June and September. 

The minutes noted that FOMC participants’ economic outlook had changed little since the March meeting.  We had expected participants to look through the first-quarter weakness, and that is what they did. • Most notable was the willingness to write off the soft consumer spending, which was attributed to lower utilities spending owing to warm weather and some dropback from an “unsustainably high fourth-quarter pace” of motor vehicle sales. Participants “expected to see a rebound in consumer spending” and pointed to the solid fundamentals, including job gains, healthy household balance sheets, and buoyant consumer confidence. 

• Housing was generally viewed favorably, with constrained supply being a bigger obstacle to growth than weak demand. 

• And the outlook for investment spending was seen as a positive. 

• Global prospects, which had been featured prominently as a downside risk not all that long ago,  were seen as brighter and less uncertain now. 

• There were a few expressions of concern: a “few” were more uncertain about the reasons for the soft consumer spending, and “several” noted that downside risks remained in the global outlook. • The staff forecast was actually raised beyond the very near term, owing to a lower projected path for the dollar. The staff also revised down “slightly” their estimate of the NAIRU. 

As for the labor market, the minutes reported the same old, same old. 

• Employment gains in the first quarter were viewed as “solid” despite the small March gain in  payrolls. 

• There was general agreement that the unemployment rate was at or below the NAIRU and would remain so for the next few years. A “few” participants continued to anticipate a “substantial”  undershooting of the NAIRU. 

• A pick-up in wage increases and worker shortages were reported in “several” Districts. • Still, “several” participants thought that a further increase in labor market utilization could occur without generating inflation pressures. 

Much as with the data on real activity, the Committee was willing to look through the recent low reading on inflation, with “most” viewing the softer inflation as transitory.

• The minutes explicitly cited the “quality-adjusted prices for telephone services.” By noting that these prices are “quality-adjusted,” they may have been signaling some questions about the reliability of measurement in this category. 

• “Participants generally” expected inflation would stabilize at 2 percent once the transitory factors receded and the economy continued to improve. 

• But as we had anticipated prior to the FOMC statement, the low inflation figures did move onto the radar screen. A “few” expressed concern that progress toward the inflation objective may have slowed and noted that uncertainty remained as to the reasons for the recent slowdown of inflation.  This camp may have increased its membership somewhat following another soft consumer price reading for April. 

The minutes certainly echoed our broad theme about the Committee’s approach to policy this year: “Back  to the plan, with a steadier hand.” 

• Despite the softness in the most recent data available at the time on spending and payroll employment, and despite the outright decline in core consumer prices in March, “most participants”  judged that a rate increase would be appropriate “soon” if data evolved “about inline” with expectations. The Committee had not been spooked by a spate of softer-than-expected data. 

• And what uneasiness there was about that view appeared to be roughly evenly distributed between those who might favor faster increases and those who might favor slower increases. • “Some” noted that inflation had been persistently below the 2 percent target for years now, and expressed some impatience in returning inflation to the FOMC’s objective. “One member” made progress toward the objective a precondition for further tightening. 

• On the other hand, “several” participants cited a set of outcomes that might necessitate a more rapid removal of accommodation, including a faster decline in the unemployment rate, a greater acceleration of wages, or more stimulative fiscal policy. 

• But the clearest message of the minutes was: Expect higher rates soon, if the data evolve as  expected. 

The FOMC appears to have arrived at a general approach for how to shrink the balance sheet once it is appropriate to do so.  

• “Nearly all policymakers expressed a favorable view” of the general approach of a plan for phasing  out reinvestment that the staff proposed and presented: 

• There would be dollar-amount caps of Treasuries and agency securities allowed to run off each month. Only the amount of principal repayments exceeding the monthly cap would be reinvested.  

• Such caps would initially be set at low levels and then be raised every three months, over a  defined period, until fully phased in. Therefore, the larger the cap, the larger the monthly reduction in the balance sheet. 

• Once fully phased in, the caps would stay at those levels until the balance sheet reached a  normal size. 

• Participants pointed out that “preannouncing a schedule of gradually increasing caps” would be consistent with the FOMC’s prior pronouncements on balance sheet policy and highlighted its ease of communication. Additional advantages cited were minimized market impact and volatility and reduced urgency to adjust the schedule as long as the economic outlook remained largely unchanged.  

• In our view, such a policy has the additional advantage of allowing the FOMC to precisely control the pace of balance sheet reduction without being constrained by the lumpy nature of the Treasury portfolio maturity profile and the uncertainty of MBS prepayments. 

• However, the variable (and for MBS, uncertain) principal repayment schedule gives rise to the operational possibility that a given month’s cap might exceed the number of principal repayments received. For this reason, the schedule of caps would define the maximum pace at which the balance sheet could shrink.  

• The proposed general approach appears to exclude asset sales for the time being.  • Although the FOMC did not make any formal changes at its May meeting to its “Policy  Normalization Principles and Plans,” participants agreed that this document should be “augmented soon”–which we interpret to mean as soon as the June meeting. Today’s minutes also provided no  guidelines, numerical or otherwise, for the potential sizes of such caps, other than to note that the  level of caps would initially be “low.” The proposal also appeared to suggest that the sizes of the caps for Treasuries vs. non-Treasuries might not necessarily be the same.  

• The preconditions for such a policy change were also expanded. In the March minutes, the reinvestment policy change would be appropriate “provided that the economy continued to perform about as expected,” while the wording in May was “as long as the economy and the path of the federal funds rate evolved as currently expected” (our emphasis). • We will follow up with a more detailed discussion of our projections for the Fed’s balance sheet.

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