No More Rate Hikes Without Higher Inflation

This was a very dovish FOMC meeting, including both the FOMC statement and Powell’s postmeeting press conference. While the FOMC indicated that the baseline outlook was little changed and remained quite favorable, it appears that this was in part because FOMC participants had marked down their expectations for future rate hikes. Overall, the explanation was a bit awkward. In fact, they gave no indication, either in the statement or the press briefing, that they expect any further rate hikes at all. What is clear is that the  FOMC and Chair Powell have elevated the importance of the incoming inflation data for any future tightening.  Powell said, “I would want to see a need for further rate increases. And for me, a big part of that would be inflation. It wouldn’t be the only thing, but it would certainly be important.” The most likely reason the Fed would tighten further would be to head off risks of above-target inflation, which seem to be minimal. At this point, they need to see it in the actual data. He also suggested that “Some of the cross-currents that I referred to may be with us for a while. And I think we’ll be looking at seeing those clear up as they relate to the outlook for the U.S.” (italics our emphasis). This raises the bar for a June hike.  

The FOMC also released a statement on Monetary Policy Implementation and Balance Sheet Normalization confirmed the widespread view that the Fed would remain in a floor system, which would require abundant reserves. The statement also affirmed that the fund’s rate will remain the preferred active policy tool, although economic conditions could compel the FOMC to change “any” aspect of the current normalization plan. We explore the implications of this statement comprehensively later in this commentary. 

The FOMC also reaffirmed its Statement on Longer-Run Goals and Monetary Policy Strategy with an updated reference to the median longer-run unemployment rate projection from the SEP. 

There were significant dovish changes to the FOMC statement. The changes surprised us primarily because of the timing, rather than the substance; several of the major changes were ones we thought they should have made in December when they had a rate hike as well an accompanying SEP. Powell argued that the changes were not motivated by a major shift in the baseline outlook, but rather by an updated assessment of downside risks. The FOMC removed the reference to “some further gradual increases” in the fund’s rate and  they removed the part saying that risks are “roughly balanced.” They added new data-dependent guidance  saying they’ll be “patient.” The reasons for this patience are “global economic and financial developments”  and “muted inflation pressures”—the latter being a new addition to the statement relative to December. The  FOMC also acknowledged in the backward-looking first paragraph that breakeven inflation rates have fallen.  There were minimal other changes to the first paragraph. 

The FOMC statement now has no explicit reference to the FOMC’s expectation for the direction of future changes in the fund’s rate. It now just references “adjustments,” rather than “increases.” We thought it would be awkward to explain the removal of this sentence now, rather than at the December 2018 meeting or the  March 2019 meeting, since it would be unclear whether and, if so, how the FOMC’s views on the appropriate fund’s rate path had shifted since December. Well, Powell’s explanation for this change was indeed somewhat awkward. He explained that the change in language “was not driven by a major shift in the baseline outlook for the economy” but rather by two things, a perception of increased downside risks to that baseline because of the “crosscurrents” (related to factors like slower global growth) and a softer inflation outlook (or at least diminished risks of too-high inflation). Powell’s language on these downside risks was markedly more hawkish  

then both his comments in December and more recent public remarks despite the fact that “most of the  incoming domestic economic data have been solid.” Indeed, while financial conditions have eased since the  December meeting and markets have become less volatile, Powell spun this in the most dovish possible way:  “Financial conditions tightened considerably late in 2018 and remain less supportive of growth than they  were earlier in 2018.” The negative news he cited was that “some surveys of business and consumer  sentiment have moved lower, giving the reason for caution.”  

Powell said that the change to the guidance was not about “a major shift in the baseline outlook.” However,  while Powell seemed to want to keep his lips pretty much sealed about the FOMC’s views on the stance of policy and future rate hikes, he then seemed to suggest that policymakers had marked down further their expectations for future rate hikes and that the outlook might have changed more if not for this. He said, “The way we think of it is that policy, we will use our policy, and we have, to offset risks to the baseline. So we view the baseline as still solid. And part of that is the way we adjusted our baseline to address those risks”  (italics our emphasis). This was the story in December, but Powell had an easier time telling it because he had an updated SEP to help him. This is a problem (though not an insurmountable one) with having a press conference at every meeting! We believe FOMC participants’ views on the appropriate path of the fund’s rate have shifted lower since December, particularly their expected number of rate hikes in 2019 (likely one rather than two). The additional hike in 2020 that they projected in December, which already seemed dubious then,  now seems even more unrealistic. 

As for whether the FOMC still continues to expect further rate hikes at all, he said, “We are not making a  judgment. We don’t have a strong prior.” He would say only that the FOMC is comfortable with the current stance of policy—well, they had better be comfortable with that stance, since they set it only 30 minutes before Powell said this! Powell’s response also didn’t address the question, since the FOMC expected to raise rates further after its December meeting but was still comfortable with its stance of policy at that time, too. He wouldn’t elaborate any further on where the FOMC sees the current setting of the fund’s rate relative to neutral and what level of accommodation it sees the economy needs. He just said, as in December, that  the fund’s rate is “now in the range of the Committee’s estimates of neutral.”  

The removal of the language on risks being “roughly balanced” is reasonable considering that it’s been clear from participants’ recent remarks that downside risks are a much greater concern than upside risks, at least for many. Indeed, that appeared to be the case even at the December meeting. So in that sense, it was an appropriate change. The FOMC didn’t change this language to say explicitly that risks are perceived to be to the downside. Given the other dovish changes, they likely didn’t feel it was necessary to provide a new language to this effect. Moreover, it might be difficult to achieve a consensus on such language, certainly at future meetings even if not at this one.  

The addition of the word “patient” to the statement as part of a shift to more-data-dependent forward guidance was no surprise. It was clear that they would add language to this effect. The addition of language about “muted inflation pressures” is more significant. Policymakers have used this phrase in their recent public remarks (including Powell in December) to justify a “patient” stance, so in that sense, it’s no surprise. But,  together with a change to the language on indicators of inflation expectation in the first paragraph, this elevates inflation as a primary consideration for any future tightening. 

For some time, the FOMC had been saying that “Indicators of longer-term inflation expectations are little  changed, on balance.” To our surprise, they continued to say that at the December FOMC meeting despite a  sharp fall in breakeven inflation rates leading up to that meeting. Now, they changed it to this: “Although  market-based measures of inflation compensation have moved lower in recent months, survey-based  measures of longer-term inflation expectations are little changed.” The first paragraph is about acknowledging the incoming data. They should have made this change in December; it’s as simple as that. Other than that,  they downgraded the rate of expansion of economic activity from “strong,” to “solid.” “Solid” is more consistent with real GDP growth of 2½% or below. “Strong” is more like 3%. So while we don’t have Q4  GDP yet, this is a reasonable adjustment to make. We don’t take much of a signal from this change.

Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization: Floor System With  Abundant Reserves Confirmed 

The FOMC also issued a statement on monetary policy implementation and balance sheet normalization. The  introductory paragraph prefaced the statement by noting that the FOMC opted to provide more information  about implementation “at this time,” following “extensive deliberations and thorough review of experience to  date.” The statement was agreed upon by “all participants,” which suggests that perhaps a subset could be comfortable with earlier adjustments to the normalization plans. The main thing the statement did was announce what we have long known, which is that the FOMC intends to remain in the current floor system with abundant reserves. Otherwise, the statement was essentially in line with previous communications about balance sheet policy. In particular, it didn’t indicate a near-term adjustment to runoff. However, just the fact that they checked this first box paves the way for filling in the details at upcoming meetings.  

Ultimately, monetary policy will operate with “an ample supply of reserves,” in which the fund’s rate will be controlled via the setting of “administered rates”—that is, IOER, ON RRP, and perhaps new ceiling tools. It  will be a regime in which “active management of the supply of reserves is not required.” This points to a large balance sheet, and likely well above the $500-billion in reserves suggested by some Fed system research.  (Market surveys indicate more than $1 trillion.) Powell also noted in his Q&A that the demand for excess  reserves will be “far larger than before.” And those estimates have also increased in recent quarters. Powell added that “there would be a buffer on top of that,” something discussed in the December minutes. Powell  described the liabilities side in this way: “after allowing for currency and circulation the ultimate size of our  balance sheet will be driven principally by financial institution’s demand for reserves plus a buffer.”  

On balance sheet normalization, the statement reiterated the Fed’s continued preference for the fund’s rate to be the primary, active policy tool. But the statement also provided for the Fed to adjust “any” of the details of the runoff plan depending on circumstances. Powell noted that “This does not mean that we would use the balance sheet as an active tool,” but rather that “occasional” changes could be warranted. 

Powell also said during the Q&A that the public’s estimates of the normalized size of the balance sheet “are  consistent with what I said, broadly speaking.” Powell said, “The implication is the normalization of the size  of the portfolio will be completed sooner and with a larger balance sheet than in previous estimates.” Plans  for ultimate balance sheet goals will be finalized “at coming meetings.” The ultimate composition of the  balance sheet will be decided “fairly soon.” These comments could provide a foundation for reducing the pace of balance sheet runoff in late 2019, perhaps with a formal announcement as soon as mid-year.  

“Moreover,” the statement noted, the FOMC would use its “full range of tools,” including “altering the size  and composition of its balance sheet,” if conditions were to merit a monetary policy stance that is “more  accommodative” than “can be achieved solely by reducing the federal funds rate.” To us, this sounds like a  preview of what the Fed easing policy would look like. Taken literally, it means that large-scale asset purchases and/or an Operation Twist-type operation would be initiated only once the fund’s rate is reduced to zero. His opening remarks expressed a similar sentiment: there could again be “conditions in which federal funds rate policy is not sufficient. In those cases, the FOMC would be prepared to use its full range of tools.” Powell  also added during the Q&A that the Fed would use the balance sheet “after” using its “our conventional tools, which would be both the fund’s rate “and forward guidance about the interest rate.”

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