Lower Underlying Inflation Making December Close Call;

Still Assuming No Hike

The FOMC will announce the beginning of the phasing out of reinvestment at next week’s meeting. No news there, no market reaction. But there likely will be a market reaction to the updated projections—most importantly, the updated dots. 

We have emphasized that the Committee’s assessment of the underlying inflation rate, uncertainty about that assessment, and the balance of risks to the inflation outlook will determine whether or not the FOMC will hike rates in December. (See What Will It Take to Raise Rates in December?

▪ The Committee has consistently expected progress toward (or beyond) the full employment objective and back to the 2% inflation objective. 

▪ And, up until March, the FOMC appeared to have become more confident in its expectation that inflation would move to 2% over the medium term and likely sooner than had been anticipated. ▪ But that confidence has been undermined by the inflation data over the last six months, making the  December call a close one. 

▪ We recently moved away from an expectation of a December hike, but it’s still close to 50/50. 

We expect the FOMC’s assessment of the underlying inflation rate will reflect a wider range of inflation indicators than is usually the case. 

▪ We now expect the 12-month core PCE inflation rate in October to be 1.4%, but we doubt anyone thinks the 12-month rate is a reliable measure of the current underlying rate. (See August CPI: Better Than  Expected, December Hike Still Close Call.) 

▪ Because price-level shocks have distorted the 12-month inflation rate, we expect the Committee to give more weight to shorter-horizon measures, which we expect to be modestly higher. ▪ We are also giving more weight to the Dallas Fed trimmed-mean measure and we expect that will get more attention from the FOMC. Like the 12-month core PCE inflation rate, it peaked at 1.9%, but it has declined since to 1.6% (July), as opposed to 1.3% (the CPI-implied August core PCE). ▪ These readings would, in our view, given the risks and uncertainties as well, lean against a move in  December, but still, leave it as a very close call. (See Inflation Scenarios: Will the Underlying Inflation Rate  Please Stand Up?

We expect some changes in the updated projections, reflecting increased momentum, the effect on economic activity and employment from Hurricanes Harvey and Irma, and additional data on core inflation. And  September is when the projections are extended an additional year, in this case to 2020. ▪ We expect the median projection for core inflation in 2017 to be revised from 1.7% to 1.5%, with a risk of a revision to 1.4%, our own projection. 

▪ Much more important and telling about the prospects for a December hike will be the median projection for core PCE inflation in 2018. That will tell us if the recently lower-than-expected readings have lowered  

participants’ assessment of the underlying inflation rate. We expect that the median projection will still rise to 2%, but by 2019 rather than 2018, consistent with the prevailing view that the FOMC remains on course for a gradual pace of rate hikes to the neutral level. 

Μarkets will mostly focus on the dots and the press conference, rather than the statement. ▪ We expect more dots to move lower, indicating a closer call between two and three hikes this year (and therefore a closer call for a December hike). 

▪ Nevertheless, we expect the median 2017 dots will still be at three hikes, still consistent with a December hike. (See Dots Will Shift Down; December Hike Could Still Be the Median But Only Barely.) 

The FOMC statement will announce the phasing out of reinvestment. The press conference will be especially informative and market sensitive. 

▪ Yellen, as usual, will present participants’ median macro projections and use that to explain any movement in the dots. 

▪ She might be asked about how the phasing out of reinvestment affects the appropriate path of the funds  rate. 

▪ She will be asked if she would stay on as Chair if nominated. She likely will deflect the question. (See Fed Chair Discussions: Cohn, Yellen, Warsh, and Others.

The Outlook Context 

We focus on our expectations for participants’ updated macro projections; that is, any revisions to how they see the outlook context for policy decisions. There will be some tweak to the growth projections, likely upward in 2018, but little, if any, change in the unemployment rate path. More important will be the inflation projections. They will lower the median projection for core inflation in 2017. We will focus mostly on any revisions to the projections for 2018 inflation, which we expect to be lower by at least a tenth (1.9%) and maybe two tenths. FOMC projections for 2020 will be included for the first time. (See Macro Views for our  recently updated macro forecast.) 

Growth Revisions Will Not Affect December Hike Odds 

There have been a lot of data on spending and production since the June projections, as well as possibly some further reductions in expectations for fiscal stimulus and the expected hit from Hurricanes Harvey and  Irma. We suspect that Q2 growth was higher than anticipated in the June projections. There now seems to be more momentum in economic activity. Until Harvey and Irma, we saw the economic activity as firming in Q3,  all the way to 3%. We expect Harvey and Irma will likely lower projected growth in Q3 but raise it in Q4 and,  to a lesser extent, in subsequent quarters. Financial conditions are more accommodative than at the time of the June projections, and global growth has strengthened. On balance, we might see a slight upward revision to 2017, even after the subtraction from Harvey and Irma. With more-accommodative financial conditions and some boost from rebuilding after the hurricanes, we expect a modest upward revision to growth projections in 2018, followed by a gradual ebbing of growth in 2019 and 2020, with growth at the longer run projected rate in 2020. We expect that any changes in the growth projections will have no implications for a December hike. 

Little, If Any, Revision to Median Projection of the Unemployment Rate 

In the June projections, the median unemployment path bottomed at 4.2% in 2018 and 2019, just a tenth below the 4.3% projected for the fourth quarter of 2017. We expect that the projected unemployment rate 

the path will be unchanged through 2019 and that the unemployment rate will also be projected to be stable in  2020, ending at 4.2%. We expect another downward revision in the median estimate of the NAIRU, from  4.6% to 4.5%. There are no implications of any revisions in the unemployment rate for the anticipated policy. 

It’s (Mostly) All About Underlying Inflation 

Participants will revise down the median projection for 2017 inflation, from 1.7% to 1.5%, or even 1.4%.  The data made them do it! 

But more important is how much FOMC participants lower their projection for core inflation in the medium term. We expect them to lower projected 2018 core inflation one or two tenths from the June projection of  2.0%, leaving a slower rise to the inflation objective, now reached in 2019. 

                        Table 1. September 2017 Median FOMC Projections 

Note: Projections of inflation and growth in the real gross domestic product (GDP) are for periods from the fourth quarter of the previous year to the fourth quarter of the year indicated. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated.

FOMC Call 

Announcement of the Phasing Out of Reinvestment 

The statement will announce the beginning of the phasing out of reinvestment, most likely in October. This decision is not very data-sensitive. 

There is a small chance the Committee could also announce—though in a separate announcement—their decision on the long-run operating framework. But there’s no pressure to do that at the same time as the announcement about reinvestment. It’s much more likely that they won’t make such an announcement, partly because they would like to get a sense of the market response to the decision on reinvestment without the interference of any additional balance sheet announcement. If they do make an announcement, it will be that they are retaining the current operating framework. 

Do I Really Have to Submit My Rate Projections? 

There seems to be a consensus that it is a close call as to whether or not a rate hike in December will be appropriate. The recent slowing in core and other measures of underlying inflation and a bit more anxiety about longer-run inflation expectations leave policymakers cautious. Think “patience.” The consensus view is that the FOMC is still on plan, still moving rates gradually to a neutral level. Some participants will continue to include a December hike in their rate projections: The real side looks strong; the economy is at or virtually at full employment, with expected above-trend growth likely to push the unemployment rate lower; inflation is still expected to move to 2% (albeit perhaps more slowly), and some will have fears about inflation heading past 2%. Others will point to the slowdown in core inflation as suggesting the underlying rate of core inflation is lower and prefer to be patient until the data reveal an upward trend from an apparently lower underlying rate. 

We suspect that every participant is struggling with this dilemma. We expect the dots will move down,  dragged lower by the unexpected slowing in core inflation, a slowing that cannot be solely attributed to price level shocks. So, there is at least less confidence in reaching 2% by 2018 or even 2019. But we expect the median to remain consistent with a December hike, though with much more of an even split. 

The dots are submitted independently, so participants do not know each other’s dots. So the dots are not intended to be a coordinated signal from the Committee—up to a point: Chair Yellen’s dot. She might be strategic in where she places her dot. At this point, strategically, it is better for the median to continue to imply a December hike. (See Dots Will Shift Down; December Hike Could Still Be the Median But Only Barely.)  That provides more optionality. A median that implies no December hike would lower the market-based probability of a December hike. The market-implied probability is now about 50/50, in line with participants’  likely current expectations. The market probability—along with ours—will move with the incoming data and will ultimately be influenced by policymaker comments as the December meeting approaches. One way or another, the Committee will better align market expectations with policy intentions, the sign of effective communication. 

Projections of the Funds Rate in the Longer Run 

We expect the median estimate of the longer-run neutral fund’s rate will edge lower, from 3% to 2¾%. Some  Committee members have marked down their estimates, and we have marked down ours from 3% to 2¾%  in our last forecast. We also expect that the median estimate of the NAIRU will edge lower by a tenth, to  4.5%. This continues the downward trend that we see as reflecting the response to continued lower-than 

expected inflation. We don’t anticipate any change to projections of GDP growth in the longer run.

Looking Ahead: Where is the FOMC Headed—or What is the Appropriate Pace? 

The appropriate pace depends on the gap between the current fund’s rate and the neutral rate (the endpoint).  All else equal, the greater the gap, the faster the appropriate pace to the neutral rate should be. Today,  emerging differences in the estimate of the neutral rate could be affecting participants’ views of the appropriate pace. 

Consider the difference between the estimate of the so-called “current” real neutral funds rate and the median estimate of that rate in the longer run. A key question is how long it will take for the current neutral rate to converge to the longer-run neutral rate, including the difference between a medium-term estimate (that is more relevant over the FOMC’s forecast horizon) and some more nebulous longer-run estimate. We shall explore this further in a forthcoming commentary. 

Financial Conditions, Asset Valuations, and the December Decision 

Financial conditions have eased recently, and have not tightened since the FOMC began to raise rates. This is a consideration that favors continuing on the path of rate hikes and, specifically, a December hike. But the influence is indirect. Financial conditions affect the forecast, which then, in turn, affects participants’  assessments of appropriate policy. We considered easier financial conditions when we upgraded our growth forecasts for 2017 (in the absence of hurricane-related effects) and 2018. 

A number of participants have talked about asset valuations, whether they are rich, and, if so, whether that should be a consideration for the pace of rate hikes. Hawks, in particular, cite these concerns to reinforce their hawkish positions, but in reality, the Committee has no idea how to adjust monetary policy if those concerns are well-founded. At this point, policymakers are prepared to rely on macroprudential policies to contain financial stability risk and keep monetary policy focused on promoting the dual mandate. 

The Message in the Statement 

The policy messages are no hike and the announcement of phasing out reinvestment. The balance-sheet decision is not subject to the same conditionality as rate hikes. As for rate hikes, a “pause” in hikes at the time of a balance-sheet announcement is seen as appropriate. 

The economy has firmed relative to expectations, but the language on growth and the labor market should be unchanged. But there will likely be a discussion of the implications of the recent hurricanes on growth and employment and how they are likely to increase uncertainty and lead to volatility in the near-term data.  Messier data, harder to extract signal from noise. At the margin, these developments reduce the information available to assess the next move. 

Still, the key will be what the statement says about inflation in the first two paragraphs—the state today and the projected convergence to its objective described in the second paragraph. At this point, we expect the narrative not to rock the boat. We don’t expect a change that would suggest less confidence that inflation,  with appropriate policy, will move toward 2% in the medium term. 

Our Guess of the September FOMC Statement 

Information received since the Federal Open Market Committee met in July June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.  Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined. Household spending and business fixed investment have continued to expand. On a 12-month basis,  overall inflation and the measure excluding food and energy prices have declined and are running below 2 

percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance. 

The widespread devastation from Hurricanes Harvey and Irma, the associated dislocation of economic activity,  and the temporary boost to energy prices for consumers imply that spending, production, and employment will be set back in the near term, though economic activity is still expected to continue rising at a moderate pace. While these unfortunate developments have increased uncertainty about near-term economic performance and increased near-term volatility, it is the Committee’s view that the near-term hit to economic activity and employment will be made up in subsequent quarters as rebuilding continues. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect that, with gradual adjustments in the stance of monetary policy,  economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely. 

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation. 

In determining the timing and size of future adjustments to the target range for the federal funds rate, the  Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information,  including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.  However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. 

For the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee decided expects to begin implementing its balance sheet normalization program, effective October 1. relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the included June 2017 Addendum to the  Committee’s Policy Normalization Principles and Plans. The Committee’s sizable holdings of longer-term securities should continue to exert downward pressure on longer-term interest rates and contribute to accommodative financial conditions. 

Voting for the FOMC monetary policy action was: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman;  Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome  H. Powell. 

Dissents 

We don’t see any basis for dissents at this meeting. Participants will reflect any differences in their respective  dots.

The Press Conference 

Chair Yellen will have an additional opportunity to move markets at the press conference. She will not want to provoke an outsized move in either direction, so she will be careful and guarded in her responses, as usual. 

As always, she will specifically link any changes in the macro projections to any changes in the rate projections. She will play down the significance of any decline in the dots. This just means what markets have already come to appreciate: A December hike is a close call, much closer than when the June dots were submitted. 

If the dots move down but the median stays at three hikes this year, she will note the downward revision to core inflation this year and next year as a consideration that affected some participants’ views about whether hiking in December would be appropriate. But her message will be that whatever the outcome in December,  participants uniformly agree that appropriate policy remains a gradual rise in the fund’s rate to its neutral level. 

The dots will likely suggest that the December decision looks like a close call at this point for FOMC  participants, a position that should not surprise anyone. However, implementing a December hike could be much more of a problem if the median 2017 dot falls to two moves. If that happens, she is likely to emphasize that a December hike is still a close call. But she would likely have to point to considerations that led participants to lower their dots that much: concern about the underlying inflation rate and how fast the economy will get to the FOMC’s inflation objective. She would be very careful if she opts to make this point but if she does, she will emphasize strongly that Committee members uniformly believe that appropriate policy continues to be to gradually move the fund’s rate to its neutral level, pointing to the dots and macro projections as indicating that the Committee’s views about appropriate policy over the medium term haven’t changed significantly. 

Given the importance of incoming data on core inflation, she will likely be asked what it would take in terms of the incoming data to lead the Committee to hike in December. She will deflect that by saying different participants have different views on what it would take. But many are giving more weight to shorter-duration inflation rates, along with the usual 12-month core PCE rate, following the price-level shock. She might cite the Dallas Fed trimmed-mean measure as well. 

She will likely be asked if she still believes that the recent slowdown in the core is mostly due to price-level shocks, and hence transitory and of little concern to policymakers. She will say that Committee members are still wrestling with the reasons behind the slowdown, but will point to the price-level shocks as explaining only part of the decline in core inflation. She may also note that, in any case, the price-level shock has a  lingering effect on the 12-month rate so it is continuing to contribute to softer readings. 

Many participants have been talking about the implications of a flatter Phillips curve. (See Trouble with the  Phillips Curve.) She might be asked if there is any concern among policymakers that a flatter Phillips curve today has diminished the FOMC’s control over inflation and, hence, eroded the FOMC’s ability to achieve the inflation objective over the medium term. She will likely say that the flatter Phillips curve is not a new phenomenon. But she will also reiterate that she continues to believe, and that staff estimates continue to indicate, that the relationship between economic activity and inflation remains strong enough for the FOMC  to achieve its inflation objective. 

As for balance sheet normalization, she could be asked what effect phasing out reinvestment will have on financial markets, and specifically on the appropriate path of the fund’s rate, notwithstanding what is likely to be no immediate market response to the announcement. In particular, she may be asked whether the dots reflected the decision to phase out reinvestment. She would likely note that, in principle, balance sheet  normalization should reverse some of the effects of asset purchases had in lowering the term premium and 

hence longer-term yields. On the other hand, quite a bit of that adjustment has been priced in already and participants have likely been incorporating their assumptions about the effect of normalization for the appropriate path for the fund’s rate for some time. Still, there is likely a range of views on the Committee about how much influence balance sheet normalization will have on the appropriate pace of funds rate normalization. 

If there is no announcement on the longer-run operating framework next week, she could also be asked why the Committee did not reveal it at the same time as the announcement on normalization. She would say that the Committee felt there was no need to make that announcement at the same time as the phasing out of the reinvestment program and that it remains the subject of ongoing discussion. She may say that the  Committee is making progress or coming to a consensus, but is unlikely to want to go so far as to signal that an announcement is imminent. 

There will be many questions on regulation, specifically her sharp disagreement with the direction that the  Trump administration appears to want to follow in rolling back some of the regulatory reform, and whether her recent comments at Jackson Hole were meant explicitly as a rebuke of the Trump Administration’s policy direction. Also, she’ll again be asked whether she would accept renomination if offered. She will likely deflect that question and say she is focused on finishing her term at this point. 

The Market Response 

The market response depends mostly on the dots, the inflation projections, and Yellen’s discussion of any downward movement in the 2017 dots; the statement is unlikely to contain any changes that would surprise markets. Although it is not our base case, if the median 2017 dot implies no December hike, then the market would substantially price out a hike in December. If that happens, however, it’s likely that Yellen would emphasize at the press conference that a December hike remains a close call and is on the table, as we discussed above—and that could lead markets to reverse some of that initial move. On the other hand, if the dots don’t change, and the median remains solidly at three hikes, as was the case in June, then the market might increase the implied probability of a December hike to above 50%.

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