Key Themes Ahead of the January/February 2017 FOMC Meeting

Following the December FOMC meeting, at which the FOMC raised the target range for the federal funds rate another 25 basis points, comments by policymakers suggested a solid consensus for three hikes in  2017. Policymakers saw the economy as continuing to improve, with the dual mandate objectives close to being met and moderate growth likely to continue. However, a large amount of uncertainty surrounded the outlook, particularly related to fiscal policy. Prospective fiscal policy changes were a focus in the intermeeting period, and policymakers continued to emphasize that they would respond to a fiscal stimulus like any other development, by assessing the likely impact on the outlook. However, many also emphasized that they will avoid allowing monetary policy to be affected by guesses of what fiscal policies will be enacted. One area in which policymakers’ comments suggested a change was the balance sheet policy.  Participants noted that a faster pace of rate hikes would imply an earlier start to the end of the current reinvestment policy. This change in sentiment encouraged us to move up our expected timing of the change in policy to mid-2018, from 2019. 

Many participants pointed to the median FOMC dots, which imply three rate hikes in 2017, as reasonable.  Most notably, Chair Yellen was much more explicit than usual about her own rate projections: “As of last  month, I and most of my colleagues…were expecting to increase our federal fund’s rate target a few times a  year until, by the end of 2019, it is close to our estimate of its longer-run neutral rate of 3 percent.” Those comments, as well as comments she made in a speech the next day, suggest to us that she is solid with the median FOMC dots from the December meeting and sees three hikes as likely to be appropriate in  2017. President Harker put himself with the median projection of three hikes in 2017, while President  Kaplan called the median projection for 2017 “a pretty good approximation” of his views and President  Williams called it “very reasonable.” President Lockhart identified himself as “on the more cautious side of  the two versus three.” President Evans had two hikes in 2017, but called the median path “plausible.”  President Mester said her path of the fund’s rate was “a little steeper” than the median in 2017, and  President Lacker suggested rates “may need to increase more briskly than markets appear to expect.” 

Like many of her colleagues, Chair Yellen provided quite an optimistic assessment of the current state of  the economy, progress made over recent years, and the economic outlook, but noted that “uncertainty is  prevalent.” Governor Powell similarly described the outlook as characterized by “tremendous uncertainty.”  Governor Brainard has long been a reliable dove, so we saw her take on the state of the economy and the  outlook as significant: “given the recent improvement in unemployment and inflation and the possibility of  increased fiscal stimulus, risks in the domestic economy are closer to being balanced than they have been  for some time.” She said that “the economy has made really nice progress over the past year toward full  employment.” There was general agreement among policymakers that the economy was at or close to full employment, with growth likely to continue at a modest pace.

Policymakers suggested that, with the economy close to meeting the dual mandate, fiscal policy initiatives that resulted in additional stimulus would very likely prompt tighter monetary policy. Governor Brainard said:  “If fiscal policy changes lead to a more rapid elimination of slack, policy adjustment would, all else being  equal, likely be more rapid than otherwise.” President Harker noted that, given the current state of the labor market, “any large stimulus to the economy may run the risk of inflation growing faster than we hope,”  while President Lockhart said “fiscal stimulus when you have a large output gap is one thing…Fiscal  stimulus when you are at full employment is another.” President Dudley put it more bluntly, saying, “If we  pushed the unemployment rate much lower, we’d have an inflation problem.” President Kaplan seemed to  view the possibility of fiscal stimulus more favorably, saying stronger growth “would allow the Fed to more  quickly normalize rates.” 

As for how they are incorporating possible fiscal policy changes into their forecasts, some said they were holding off on making assumptions. President Harker was one of those, saying, “Right now it’s impossible  for me to factor any of those into a forecast because I don’t know what those policies will be.” He noted that there is uncertainty even about the direction of the impact of policy changes: “There are policies that could cut both ways: when there’s a fiscal stimulus, that, of course, we’d have to factor into account with respect to inflation and inflation expectations. But if there are trade barriers put up, that can also have a  negative effect.” Of market expectations of substantial fiscal stimulus, President Kashkari said: “markets are notoriously bad at predicting political outcomes…I have no greater confidence that markets can tell us  exactly what the new Congress and the new administration are going to do, and so I want to see a lot more  information before that really changes my perspective.” Others were willing to go out on a limb and discuss  the possible economic impacts of fiscal policies. President Evans said that fiscal stimulus “might increase  growth by a couple of tenths over the next two years.” He added that “we look forward to refining that  when we actually see proposals that are moving forward and likely to be implemented.” 

Some also commented on downside risks that might be associated with specific policy changes. President  Dudley was concerned that a border adjustment “would lead to dramatic changes in the value of the  dollar,” so he hoped that any change would be “a little bit less dramatic.” President Harker, like others, was  concerned that a trade war following changes to trade policies could be very damaging: “If we had a  significant trade war, say with China, the lower 10% of the income distribution would lose 50% of their  purchasing power.” 

For the first time in a while, balance sheet policy returned as a regular topic of discussion, with policymakers suggesting that balance sheet policy will be a focus for the FOMC in the coming year.  President Kaplan suggested the FOMC should consider allowing some runoff “probably sometime later in  this year, early next year.” Governor Brainard’s comments suggested that a faster pace of rate hikes would  likely translate to an earlier end of reinvestments, since “the conditions the FOMC has set for a cessation of  reinvestments of principal payments on existing securities holdings [would be] met sooner than they  otherwise would have been.” President Harker suggested that the FOMC should consider changing the reinvestment policy once the fund’s rate reaches a threshold of one percent. President Bullard suggested  that “Adjustments to balance sheet policy might be viewed as a way to normalize Fed policy without  putting exclusive emphasis on a higher rate path.” Chair Yellen noted that even now, with full  reinvestments, the downward pressure that the Fed’s asset holdings put on longer-term interest rates “is  estimated to be gradually easing as the average maturity of the portfolio declines and the end-date for  reinvestment draws closer.”

President Williams emphasized that the FOMC would communicate any changes very clearly so that any  changes going into effect “won’t be disruptive at all.” He added that allowing the Fed’s portfolio to begin running off “will cause interest rates to go up,” a “desirable” effect. As for the question of the size of the  

balance sheet in the longer run, President Harker said that it is very much open and currently being researched, but noted: “that process will take years to create whatever the new normal is with respect to the balance sheet. We have some time to think that through.” President Kashkari likewise saw the question  of balance sheet policy as wide open: “We need a lot more information, in my mind, before we can make  any forecasts about what it would mean for the balance sheet.“

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