The recent weakness in inflation was a key focus of policymakers in the period ahead of the July FOMC meeting. Policymakers expressed varying degrees of concern about the prospect that the recent data might indicate some underlying weakness, but the consensus was that the basic inflation outlook remained intact. Having raised the fund’s rate in June, and another hike likely off the table until December, policymakers were in a “wait-and-see” mode. Moreover, there’s a strong consensus among FOMC participants that the next policy move will be an announcement of a change in reinvestment policy, not another funds rate hike, and that the decision to begin to allow runoff will be much less dependent on the incoming data. Thus, policymakers were comfortable with the stance of policy, waiting to see if the inflation data suggest that a change in the inflation outlook, and a change in the policy rate path, is warranted.
Chair Yellen delivered her second semiannual monetary policy testimony of the year, which didn’t provide any big surprises. The main takeaway was that Yellen maintained her inflation outlook despite the recent weakness in core inflation: “It’s premature to conclude that the underlying inflation trend is falling well short of 2 percent. I haven’t reached such a conclusion” (7/13). She attributed the weakness at least in part to transitory factors, the “in part” being an important qualification. She cited declines in prices for cell phone service and prescription drugs in particular as transitory factors that would continue to depress 12-month inflation rates until they drop out of the calculation. She did, however, suggest that the incoming inflation data would be critically important in upcoming decisions to continue gradually raising the fund’s rate: “I do believe part of the weakness in inflation reflects transitory factors but will recognize inflation has been running under our 2 percent objective, that there could be more going on there. It’s something that we will watch very carefully and will be a factor in our future decisions about rate increases” (7/12). The remark that “there could be more going on there” in particular shows greater anxiety about the underlying rate of inflation.
Many of Yellen’s colleagues made similar points about inflation dynamics and how inflation would factor into upcoming decisions on whether to raise the fund’s rate. The consensus was very clearly for one more rate hike this year, in December, conditional on the data. Governor Brainard said that, once the FOMC had begun allowing securities to run off its balance sheet, “I will want to assess the inflation process closely before making a determination on further adjustments to the federal funds rate in light of the recent softness in” core inflation (7/14). President Harker hinted that his support for further rate hikes would depend on the inflation data firming up, noting that a failure to do so would give him “a little pause in terms of the policy path” (7/11). Previously, he had said that he still favored another rate hike this year, even though he’d revised his views “slightly on meeting our inflation goal from the end of 2017 to the beginning of 2018” (6/27). President Williams likewise still expected the inflation objective to be reached “in the next year or so” (6/27). President Kaplan was perhaps even firmer, seeming to draw a pretty clear line in the sand with respect to the incoming inflation data: “I would now at this point like to see more evidence that we’re making progress in meeting our inflation objective before we take further steps in removing accommodation. I’ve been counseling
patience” (7/14). President Evans said, “I think it’s going to be important to see several months of markedly better inflation data” (6/19). He said that the FOMC could put off a rate decision until December, at which point the FOMC could “make a judgement that maybe three is the right number, maybe two is the right number” (6/20). Justifying his decision to dissent at the June FOMC meeting, President Kashkari appeared far more skeptical than his colleagues that the recent run of softer core inflation data did not reflect weakness in the underlying rate of inflation. President Bullard also had greater doubts about the trajectory of inflation as well as the pace of rate hikes that most of his colleagues were projecting, saying that “recent inflation data… calls into question the idea that U.S. inflation is reliably returning toward target” (6/29).
Chair Yellen continued to show faith that the Phillips curve relationship between the labor market and inflation would eventually assert itself: “We have seen increased strength in the labor market that continues, and although there are lags in this process, I believe that that’s something that, over time, will put upward pressure on both wages and prices.” (7/13). For this reason, she still saw inflation risk as “two-sided.” Many of her colleagues made similar remarks about the Phillips curve. President Dudley said: “We think if the labor market continues to tighten, wages will gradually pick up, and with that, we’ll see inflation get back to 2 percent”
(6/19). He also described inflation as only “a little bit lower than what we would like.” President Kaplan said: “As we remove slack from the labor market, you’re going to see…with a time lag, likely see more wage pressure, and some of that will likely translate into greater inflation pressure. That’s my theory” (7/13). As many of his colleagues have done, he noted that you would have “historically seen more inflation pressures” associated with what is currently “a relatively low amount of labor slack.” Governor Brainard made the same point more succinctly: “The Phillips curve just seems to be very flat” (7/13). President Harker said “I do not believe the Phillips curve is dead forever. I do not think the relationship between unemployment and inflation is broken. It’s still there, it’s just changed. When it will reassert itself, I can’t tell you” (6/27).
We saw policymakers’ remarks as signaling quite strongly that an announcement on balance sheet policy would be made at the September meeting. Indeed, even the policymakers most concerned about tightening policy too much by raising the fund’s rate, Presidents Kashkari and Bullard, advocated beginning to normalize the balance sheet. In her testimony, Yellen did give a little bit of information about her personal views about the timing of an announcement of the phasing out of reinvestment, saying it should be done “relatively soon.” She added that “the exact timing of this, I don’t think matters a great deal. It is something we’ve long been preparing to undertake.” These remarks reinforced our belief that the announcement will come in September, and that the bar is lower in terms of the incoming economic data for an announcement on reinvestment than it is for the next fund’s rate hike. Moreover, Governor Brainard said that “it would be appropriate soon to commence the gradual and predictable process of allowing the balance sheet to run off” as long as “the data continue to confirm a strong labor market and firming economic activity,” conspicuously omitting inflation from her list of the relevant data. President Bullard, who has been advocating for beginning the normalization of the balance sheet for some time, nonetheless favored waiting until September, saying, “I think it’s more prudent to wait to announce balance-sheet adjustment at a press conference meeting.” There were differences in views among policymakers about whether it would be okay to announce a change in reinvestment policy and raise the fund’s rate at the same meeting. However, we don’t see this as an issue, since the FOMC appears set to change its reinvestment policy in September and there’s no urgency to also raise the fund’s rate at that meeting.
Governor Brainard distinguished herself from her colleagues on the Board by weighing in on her preferred longer-run operating framework for monetary policy. Like many of her colleagues, she noted that the current operating framework “works very well,” but she went further by saying, “I would anticipate remaining in the current framework.” She noted, however, that the ultimate size of the normalized balance sheet wouldn’t be
know for “some time.” In her testimony, Chair Yellen did not go into detail about the longer-run monetary policy framework, noting only that the issue had not been decided.
Policymakers also commented increasingly on financial conditions and the possibility of “complacency” leading to disruption in financial markets. Those who commented on valuations generally said something similar to what Chair Yellen did: “Asset valuations are rich if you use some traditional metrics like price-earnings ratios, but I wouldn’t try to comment on appropriate valuations” (6/27). Governor Fischer said, “overall, a range of indicators point to a vulnerability that is moderate when compared with past periods” (6/27). He warned that “the increase in prices of risky assets in most asset markets over the past six months points to a notable uptick in risk appetites” and “close monitoring is warranted.” President Williams was apparently more willing to give his opinion on equity prices, saying, “the stock market still seems to be running very much on fumes” (6/27). However, he saw the risk of a correction as manageable: “I’m not worried about some kind of late-90s dot-com bubble economy where a lot of the underpinnings were driven by the stock market.” President Dudley discussed financial conditions in the context of the Fed gradually normalizing interest rates and removing monetary accommodation: “when financial conditions ease—as has been the case recently—this can provide additional impetus for the decision to continue to remove monetary policy accommodation” (6/26).
The minutes of the June FOMC meeting were the first to include a comprehensive discussion of what we have called the “substitution effect,” the effect that the normalization of the balance sheet has on the appropriate path of the fund’s rate. Several participants saw the commencement of balance sheet normalization as “one basis for believing that…the target range for the federal funds rate would follow a less steep path than it otherwise would.” Others did not see the balance sheet normalization as “likely to figure heavily in decisions” about the path of the fund’s rate. In her testimony before the Senate, Chair Yellen touched on the substitution effect, perhaps identifying herself as a member of the first group: “Over many years, as our balance sheet shrinks, we would expect to see some increase in longer-term interest rates relative to short-term interest rates. But of course, we will take that into effect, namely a steepening of the yield curve, in how we set the federal funds rate” (7/13).