As Expected, A Bit More Concern About Inflation

The minutes of the July FOMC meeting didn’t provide any big surprises or shed much light on how many  FOMC participants continue to expect three rate hikes this year, meaning another in December. The discussion in the minutes was consistent with our view that the key issue facing the FOMC is the pace of core inflation.  Specifically, the FOMC wants confirmation that it’s on track to reach its objective in the medium term before it raises rates again. It’s clear that concern about the underlying rate of inflation has increased as core inflation readings have continued to come in soft. Our call remains that there will be a December hike, though this is admittedly a close call now, given that the monthly readings for core consumer price inflation have continued to come in soft after the outright decline in core PCE prices in March. On the other hand, we believe that the softer readings for core inflation will not stand in the way of the announcement of a change in reinvestment policy at the September meeting. 

The FOMC continued to disagree about the reasons behind the recent softness in inflation, although the general tone appeared a bit less upbeat than in June. 

▪ There was clearly an increase in concern: “Some participants expressed concern about the recent decline  in inflation, which had occurred even as resource utilization had tightened, and noted their increased  uncertainty about the outlook for inflation.” 

▪ In July, “many” participants thought that much of the decline could be attributed to idiosyncratic factors.  In June, “most” participants thought so. This indicates that more participants than before seeing the  slowdown in inflation as potentially persistent. 

▪ Participants agreed with our view (as we wrote in our note earlier today) that PCE inflation “on the 12- month basis” would continue to be held down through the second half of 2017, and “monthly readings”  would provide additional information the Committee would surely also pay attention to. 

▪ Residual seasonality was cited as an additional factor that might weigh on monthly inflation readings late in the year.1 

▪ While “several” in June were concerned that progress toward the objective had slowed and the softness might persist, “many” in July saw some likelihood that inflation would stay below the objective for longer than they currently expect. 

▪ Nonetheless, “most” saw inflation reaching the 2 percent objective over the medium term. 

1 Footnote: See Ekaterina Peneva (2014). “Residual Seasonality in Core Consumer Price Inflation,” FEDS Notes. Washington: Board of  Governors of the Federal Reserve System, October 14, 2014, https://www.federalreserve.gov/econresdata/notes/feds notes/2014/residual-seasonality-in-core-consumer-price-inflation-20141014.html 

There appeared to be a vigorous discussion on the use of the Phillips curve for informing policy decisions,  consistent with the attention this topic has received in participants’ public remarks. ▪ “Most,” thought the framework remained valid—“notwithstanding the recent absence of a pickup in  

inflation” even as the labor market tightened and GDP growth exceeded potential growth. Nevertheless,  “a few” argued that the Phillips Curve was not useful in forecasting inflation. 

▪ Participants explored why inflation remains so subdued even though unemployment is low. Among other  possible reasons, they mentioned: a lower NAIRU, the U-3 unemployment rate might misrepresent the  degree of labor market slack, lagged responses of inflation to resource pressures, downward pressure on  inflation from “global developments,” and “innovations” to business models spurred by “advances in  technology.” 

▪ Nonlinearity in the Phillips curve was also a point of contention. “A couple” argued that appreciably overshooting full employment could bring about a stronger response of inflation to resource slack, but  “other” participants argued that there was little empirical support for this. 

▪ All in all, the discussion in the minutes of the Phillips curve highlighted, yet again, the long-standing split within the Committee on this issue. 

There was an extensive discussion on financial conditions at this meeting, and from a couple of different angles:  (1) why financial conditions have remained quite accommodative even as the Fed has raised the fund’s rate,  and how monetary policy should respond to that situation, and (2) whether asset prices are overvalued and whether that presents risks to financial stability. 

▪ Still-elevated equity prices clearly were a focus of considerable discussion. One view was that “a tighter monetary policy than otherwise was warranted” because “other factors influencing financial markets”  had “largely offset” the FOMC’s actions to remove accommodation. 

▪ The alternative view mentioned in the minutes was that there might not be a meaningful boost to spending  from the recent rise in equity prices if that rise is “part of a broad-based adjustment of asset prices to  changes in longer-term financial conditions, importantly including a lower neutral real interest rate.” 

▪ Participants also discussed the implications of low longer-term rates: “A number of participants pointed  to potential concerns about low longer-term interest rates, including the possibility that inflation  expectations were too low, that yields could rise abruptly, or that low yields were inducing investors to  take on excessive risk in a search for higher returns.” 

▪ The staff reported that potential risks to financial stability remained “moderate on balance,” but we found it interesting that the staff’s view was that “since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets” (italics our emphasis). 

▪ Financial stability concerns were echoed in the discussion of monetary policy. Some participants warned  that a delay in the gradual removal of accommodation could result in “an intensification of financial stability  risks and to other imbalances that might prove difficult to unwind.” 

▪ Nevertheless, we still saw the Committee as prepared to rely, at this point at least, on macroprudential policy to address financial stability issues. In this regard, the Committee emphasized the importance of the current regulatory framework, imposed after the financial crisis. 

▪ “One” participant—perhaps Chair Yellen—concluded the policy discussion by reiterating the need to  “strike the appropriate balance” between the dual-mandate objectives and “mitigating financial stability  concerns.” 

The Board staff as well as FOMC participants continued to scale back their expectations for fiscal stimulus.

▪ This seems entirely appropriate, given the lack of progress Congress has made in passing any legislation. ▪ We have continued to assume a fiscal stimulus in our own forecast, but we too will be reconsidering that assumption in our next forecast. 

▪ While the Board staff and FOMC participants have been adjusting their fiscal assumptions, their forecasts have remained little changed. In regard to the staff forecast, the minutes noted that “the effect of this  change on the projection for real GDP over the next couple of years was largely offset by lower assumed  paths for the exchange value of the dollar and for longer-term interest rates.” 

We remain confident that the FOMC will announce a change in reinvestment policy at its September meeting. ▪ We see this decision as not being impacted by the recent slowing in core inflation. ▪ “Most” participants wanted to defer a decision to announce a start date until “an upcoming meeting”  even though “several” were prepared to do so at the July meeting. ▪ It was acknowledged that central bank asset purchases were “likely contributing to low term premiums”  (although the degree was “uncertain”) and that low longer-term yields “could rise abruptly.” ▪ However, “many” pointed out that the change in reinvestment policy would contribute “only modestly”  to the reduction on overall accommodation. Additionally, the minutes cited survey responses from market  participants as suggesting that the effects on bond yields and MBS spreads from the change in  reinvestment policy would be “modest.”

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