Risk Management Well Past June

Rate Policy 

• The minutes underscored the newly “patient” approach of the FOMC and were consistent with a  pause lasting at least through June, if not for longer. Risk management likely to prevail through June,  if not longer. But the muted inflation picture suggests that a pause is likely to morph into the end of the tightening cycle. 

o “Participants,” thought that pausing “for a time” presented “few risks at this point.” They cited the fund’s rate as having reached the lower end of neutral, muted inflation pressures, and less stretched asset valuations (less financial stability risk). 

o “Many” participants noted it was not yet apparent “what adjustments” (not necessarily  upward) would be needed “later this year.” Of those, “several” thought rate hikes “might prove necessary only if” actual inflation outcomes exceeded their baselines. 

o Several others thought that their baseline would warrant raising the target range later this year. We interpret that as meaning only one hike. 

o To us, this suggests that the risk-management phase will last well past the June meeting. o Absent from the minutes, in general, was an emphasis on the Phillips-curve type framework which would draw a strong link between continuing labor market strength and upward inflation pressures. Indeed, the reference to “muted” inflation pressures in light of labor market improvement is a demonstration of the flat slope of the Phillips curve. Additionally, the staff suggested that the tightness of the labor market behooves policymakers to monitor the labor force participation rate more closely. 

• The FOMC appears to share our assessment that growth will likely slow, but remain above trend this year, slow to trend in 2020, and then to a below-trend rate in 2021. As a result, it expects the unemployment rate to fall this year, stabilize next year, and rise in 2021. An important question is why the Committee sees appropriate policy as calling for below-trend growth and a rise in the unemployment rate later in the forecast horizon. 

• The inflation picture continued to vex policymakers. They held fast to their view that inflation at 2  percent remains the most likely (modal) outcome. But “many,” said upward pressures on inflation were more muted than in 2018 even though labor market conditions had improved and, some industries were facing higher input costs. That is, those higher cost pressures were not being passed through to price inflation. 

o The FOMC took solace in survey-based measures of inflation expectations remaining steady,  which in their view offset the weakness in TIPS-based inflation compensation. Indeed, they pointed to the steadier survey measures as supporting evidence for the hypothesis that the declines in TIPS BEIs merely reflected technical factors. However, the Michigan survey measure has also declined. 

• The change in policy posture to patience was primarily motivated by increased downside risks and greater uncertainty about the outlook. The minutes listed a litany of sources. Although many of the causes were foreign (slower global growth (especially China and Europe), and Brexit), domestic factors such as “rapid waning” of U.S. fiscal stimulus, intensification of trade tensions, and additional partial government shutdowns were also cited. Notably, participants also mentioned further tightening of  

financial conditions as a risk, and that is the only risk over which it exercises some measure of control.  However, the minutes steered clear of making too explicit a link between U.S. trade negotiations and foreign economic weakness. Specific sectoral weaknesses in agriculture and manufacturing were also mentioned. The only counterbalancing factor offered was the chance that such uncertainties might recede more quickly than anticipated. 

• In their view, patience would buy them time to assess changes in sentiment, the persistence of “recent softness in inflation and inflation compensation,” and the effect of tightening financial conditions on aggregate demand. Indeed, participants were hopeful that ongoing budget negotiations would yield clearer outcomes for the fiscal policy path. 

o Another important factor was the need for some time to assess the cumulative impact of Fed  tightening to date. 

o However, the FOMC is already thinking ahead about how to extricate the statement from  “patience.” “Many,” thought that if uncertainty became less intense, the “patient” wording might have to change. 

• Although risks being weighted to the downside was apparent at the meeting to observers, the FOMC  chose to omit the sentence on the balance of risks from the statement, and the previous wording would be accurate and new wording that would correctly reflect the new downside picture would prove too jarring. 

Balance Sheet 

• The minutes provided the most definitive signal to date that balance sheet runoff will end soon.  “Almost all” participants supported ending runoff “later this year.” To be more specific, the staff  presented options for ending runoff “at some point over the latter half of this year.” In other words,  2019:Q3 or 2019:Q4. 

o In our view, the runoff alternatives that the staff presented likely included tapering the runoff caps to allow the Fed to approach the efficient level (with a buffer). Tapering is also consistent with the lag between a likely mid-year announcement and the later-in-2019 conclusion to runoff. 

• Although the end of runoff is anticipated to be in the second half of the year, an announcement would  be made “before too long.” Given that previous usage of “before too long” in the FOMC minutes corresponded to roughly 3-6 months, the June FOMC meeting seems like a natural venue for a new runoff plan. 

• Once runoff ends, the SOMA portfolio would be held “roughly constant for a time” such that reserves would continue to decline, albeit much more gradually, as other liabilities (such as currency) grow over time if the balance sheet is held constant. A “substantial majority” (less than “almost all”)  anticipated that when runoff has ended, the level of reserves would still be “somewhat larger” than the efficient level. In their view, that would allow the Fed to “arrive slowly” at the efficient level. 

• The minutes imply that most participants were on board with the staff proposals to hold the SOMA  portfolio steady after the end of runoff. But “a few” thought that the consequent decline in reserves would be too risky. They instead favored the Fed conducting outright purchases of securities (likely  Treasuries) to keep reserves constant as non-reserve liabilities grow. “A couple” suggested a “ceiling facility,” likely a repo program, could mitigate money market pressures with fewer reserves and keep the fund’s rate trading at or below the upper bound of its target range. 

• An emerging issue was the desired composition of the asset portfolio. The FOMC was in agreement of a transition toward an all-Treasuries portfolio, the question was at what speed. An indeterminate number of “participants” (likely less than a substantial majority but probably more than a number)  thought that once runoff ends, “most, if not all” agency MBS paydowns should be reinvested in  Treasury securities. 

o In light of market speculation that the Fed would seek to lower its portfolio maturity by redirecting MBS paydowns specifically into Treasury bills (rather than coupons), the choice of  Treasury “securities,” which encompasses both bills and coupons, is notable.

o “Some” thought that the current practice of reinvestment MBS paydowns above the cap back into MBS would protect against prepayments spiking on interest rate declines and be easier to convey. But “some others,” thought the MBS cap was unnecessary as it is unlikely to be binding, and retaining it would slow the composition-normalization of the portfolio. This discussion was also an oblique disagreement over the likely trajectory of longer-term yields.  The FOMC has not reached an agreement on how to change MBS runoff, and they expected a  decision would be made at upcoming meetings. 

• Finally, the entire discussion of balance sheet normalization was presented as a consideration of technical factors such as efficient conduct of reserves and monetary policy, rather than being primarily motivated as a response to recent macroeconomic information. • Nevertheless, participants agreed that the normalization process should be “flexible” and respond to the evolution of economic and financial data. That is, data-dependent, just like rates policy.

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