Still “Wait and See,” but Increased Emphasis on Room for Patience

Continued weakness in core inflation remained a key focus of policymakers in the period ahead of the  September FOMC meeting. As successive readings came in soft, there was a corresponding increase in concern about the underlying rate of inflation. Still, policymakers remained very much in a wait-and-see posture, preferring to wait to make a judgment until they have more data in hand. Like us, policymakers seem to see it as a very close call as to whether a third-rate hike this year will be appropriate. And there’s no need to make a judgment now since a rate hike is off the table at this week’s meeting and the decision to begin phasing out reinvestment isn’t data dependent at this point. At this week’s meeting, the FOMC will almost certainly announce that it will start phasing out reinvestment of its maturing asset holdings; the lack of any signaling to the contrary in policymakers’ remarks virtually guarantees this, given that markets are fully expecting an announcement this week. FOMC participants discussed in some depth the economic impact of  Hurricanes Harvey and then Irma, with the consensus being that there would be considerable short-term disruption but that there was unlikely to be any effect on the medium-term outlook.  

Probably the most substantial piece of communication by FOMC participants during the intermeeting period was Governor Brainard’s speech titled “Understanding the Disconnect between Employment and Inflation with a Low Neutral Rate” (9/5). As we wrote in our commentary about her speech, she indicated that she,  like so many of her colleagues, is in a wait-and-see posture because of the uncertainty around what the underlying rate of inflation is. She said, “I am concerned that the recent low readings for inflation may be driven by depressed underlying inflation, which would imply a more persistent shortfall in inflation from our objective. In that case, it would be prudent to raise the federal funds rate more gradually. We should have  substantially more data in hand in the coming months that will help us make that assessment.” She didn’t seem to give much weight to the argument that transitory factors are to blame for the recent weakness in core inflation, though she wouldn’t rule it out. 

In any case, her speech had a broader focus: “What is troubling is five straight years in which inflation fell  short of our target despite a sharp improvement in resource utilization.” As she has previously, noted that  the Phillips curve appears to be very flat, so much so that “there are reasons to worry that the Phillips curve  will not prove very reliable in boosting inflation as resource utilization tightens.” She linked the concept of underlying or trend inflation to the notion of longer-term inflation expectations and argued that there is evidence suggesting there’s been a decline. With the Phillips curve so flat, “achieving our inflation target on a sustainable basis is likely to require a firming in longer-run inflation expectations–that is, the underlying trend,” she said. 

She also discussed in some depth the neutral fund’s rate, arguing that issues related to the neutral rate are another reason (in addition to depressed underlying inflation) for caution in raising the fund’s rate further. For one, estimates of the longer-run equilibrium funds rate have fallen, suggesting that the FOMC doesn’t have as far to go to reach neutral as in previous tightening episodes. In addition, by beginning to normalize its  balance sheet, the FOMC is removing policy accommodation by another lever, warranting fewer funds rate  

hikes–what we refer to as the substitution effect. On top of that, foreign central banks are likely to begin normalizing their balance sheet policies as well, adding to upward pressure on longer-term interest rates. 

For all of these reasons, Brainard argued, there’s good reason for the FOMC to err on the side of caution in normalizing policy. It’s quite clear that at this point she doesn’t see another rate hike this year, in December,  as likely to be appropriate, and it would take a substantial change in the data for her to change her position.  While Brainard remains at the dovish end of the FOMC, her arguments for patience now seem more likely to resonate with the center of the Committee. In particular, now that the FOMC has moved the federal funds rate well away from zero, more FOMC participants are making the point that, given the low neutral rate,  there’s less accommodation being provided than there might appear, so the FOMC can be patient in removing the remaining amount. 

Speaking shortly after Governor Brainard, President Dudley also made some high profile remarks on inflation,  but his take on structural factors driving inflation contrasted with Brainard’s discussion: “If it turns out that structural changes have played a significant role [in recent soft inflation], I would generally view this as a  positive, rather than negative, development,” the reason being that the FOMC could then allow the unemployment rate to fall even further (9/8). Previously, in August, he had indicated that he expected to support a third-rate hike this year. In these remarks he again seemed to express openness to raising rates  further this year, but was much more noncommittal, saying, “It’s too soon to judge exactly the timing of  when the next rate hike might occur, but the path is still clear that short term rates are going to move higher.” 

Inflation dynamics continued to be a focus of FOMC participants, of course. Many noted that the Phillips curve relationship between the labor market and inflation does not seem to be working as expected, though they generally expressed their faith in the general concept. President Dudley reiterated that, in his framework,  wage gains would cause firmer price inflations: “we do expect as the labor market continues to tighten, to  see firmer wage gains and that will ultimately filter into inflation moving up towards our 2% objective.”  President Dudley, like some of his colleagues, noted that the 12-month core PCE inflation rate would be held down for some time by very weak readings earlier this year. Thus, he said, “It’s really important to distinguish what’s happening sequentially” following the weak monthly readings (8/10).  

Several FOMC participants commented on the possibility of structural change in the inflation process, in particular technological changes. President Kaplan noted that “technology-enabled approaches” are “limiting the pricing power of businesses, which is also having a muting effect on inflation. So I think you have a little bit of a collision between the cyclical forces and the structural forces, and I think the structural forces are far more powerful than people may realize” (8/15). President Bullard approached the issue from another angle,  pointing out that “The technology share of every single good is getting bigger. Those prices are tending to  drop” (8/9). President Evans said, “people are utilizing newer technologies, competition is emerging from  unexpected places — not necessarily your nearest competitor but somebody else — and that could lead to 

reduced margins and downward price pressure for some period of time” (8/9). 

Overall, there was a dovish shift in policymakers’ remarks over the intermeeting period, consistent with the incoming soft inflation data, though the overwhelming theme was that FOMC participants were in a wait-and-see mode since there was plenty of time before a rate hike decision would be considered. Despite their concerns about inflation, however, policymakers overwhelmingly indicated that they were maintaining their expectation that inflation will return to its objective in the medium term. The word “patient” came up again and again. Governor Powell said, “I think it’s too soon to make decisions about particular meetings and whether to raise rates, but I think we have the ability, if we keep getting strong growth and strong labor markets, we have the ability to be a little bit patient and that’s not a bad thing” (8/25). Board Vice-Chair  Fischer was likewise noncommittal, saying about the recent inflation readings, “There will be arguments on both sides on this thing. I’m not sure where that discussion is going to end up. This continuation of lower 

than expected inflation rates is something we have to think about” (8/15). President Bostic’s early public remarks seem to indicate that he’ll be near the center of the FOMC, perhaps with a dovish lean. We haven’t seen “the sustained level of inflation that all of our economic models say should exist…So if we don’t see that kind of inflation, my view is that we should try to be somewhat more hesitant in moving stridently in any direction. Let’s wait and see” (8/16). 

President Kaplan seemed to show a shift in his views. Previously we had seen President Kaplan expecting three hikes as likely to be appropriate this year, and before the last FOMC meeting, he had made clear he needed to see an improvement in the inflation data before supporting another rate increase. His recent remarks indicate a shift, and we expect his dots to be consistent with two hikes this year, meaning no hike in  December. He said, “I’m not saying we won’t act by the end of the year, but we have the ability to be patient” (8/24). Referencing the uncertainty about recent soft inflation readings, he noted, “where there’s a  conflict, I think it pays to be patient.”  

FOMC participants who have been more hawkish still emphasized the importance of staying on a path of normalizing the fund’s rate, but there was perhaps somewhat less urgency in their remarks. President Mester allowed that inflation “is not yet” at its objective, but noted that “we have to move policy a little bit before we get to the goals or else we’re going to get behind” (8/26). She previously said that “So far I still think the factors are in place for inflation to rise. I don’t want to overreact to a couple of reports on inflation. At the same time, there could be something more going on and I want to look at the data” (8/2). President George, probably the FOMC’s most reliable hawk today, said that, “based on what I see today, I think there’s still opportunity”  for a third hike this year (8/24). 

Policymakers commented on the likely economic effects of Hurricanes Harvey and then Irma, seeing a  likelihood of substantial disruption but signaling that they did not expect to revise their overall outlooks because of these events. Brainard commented that “Based on past experience, it appears likely that the hurricane will have a notable effect on GDP in the current quarter, although output is likely to rebound by the end of the year” (9/5). Brainard, like her colleagues, saw the spike in gasoline prices due to the disruption to  refinery infrastructure as likely “short-lived.” Their comments also suggested that the hurricanes were unlikely to affect the December FOMC decision about whether to raise interest rates. The increase in energy prices  would temporarily raise headline inflation, but price impacts of the hurricanes were not seen as relevant to  the FOMC’s current focus, assessing underlying inflation, because “temporary factors, by their nature, have  little implication for the underlying trend in inflation.” President Dudley allowed that “it’s possible they could have [an] effect on the timing of short-term rate increase, but I think that’s probably further out anyway. So  I would suspect when we get to the end of the year and early 2018, the transitory effects I think will be over and we’ll actually be starting to see some of the benefits of the rebuilding efforts in terms of boosting the economy” (9/8). 

Chair Yellen’s Jackson Hole speech in late August was highly anticipated by markets (8/25). However, as expected, Chair Yellen did not move markets with a discussion of the economic outlook or monetary policy.  She opted instead to focus entirely on regulation, providing a comprehensive defense of post-crisis regulatory changes while allowing that certain aspects could be revisited. Apparently many saw this speech as suggesting lower odds of Yellen serving another term as Chair once her current term ends since her defense of the current regulatory regime would seem to put her at odds with the current administration. 

The FOMC has communicated very clearly that an announcement of a change in balance sheet policy is coming soon, and public remarks by FOMC participants virtually guarantee an announcement at this week’s meeting. Governor Powell said, “we’ve socialized that plan and the markets seem to have accepted it, and I  do think the time will be here soon for us to begin to normalize monetary policy, the balance sheet” (8/25).  President Kaplan was even more explicit, saying the process of allowing balance sheet runoff should begin 

“very soon,” with the announcement coming “as soon as the September meeting” (8/24). President Evans likewise said a September announcement would be “quite reasonable” (8/9). Earlier in the intermeeting period,  some FOMC participants had mentioned that the debt ceiling issue might delay a September announcement.  However, with a deal reached to delay the debt ceiling becoming binding until later in the year, that’s no longer an obstacle.

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