Uncertainty about Inflation Occupies the Committee

There will, of course, be no rate hike, and an announcement on phasing out reinvestment is extremely unlikely. ▪ This is not a decision meeting, though of course, we await the communication in the statement. ▪ At this meeting, FOMC participants will focus on assessing underlying economic conditions, in particular the sources of the slowdown in inflation and whether there are signs of growth momentum slipping. 

Our FOMC call remains unchanged: 

▪ An announcement of the phasing out of reinvestment in September. We already know all the details we need to know, other than the date of the announcement and the timing of the actual beginning of runoff. ▪ A third rate hike of the year in December, though the probability of a December hike has diminished as a  result of the softer inflation data. 

There has been speculation about the possibility of an announcement about the phasing out of reinvestment at next week’s meeting. 

▪ That speculation has been prompted by remarks attributed to a couple of participants in the June minutes and by Governor Brainard’s speech at a conference at the New York Fed. 

▪ We believe there is very little chance, almost none, of an announcement on the balance sheet next week.  Signaling, yes. An announcement, no. Rule #1 for balance sheet policy: No surprises, period. ▪ Still, we have to understand that this speculation reflects concern that fiscal uncertainties may confront the FOMC as early as September. 

Fiscal uncertainty and risks are growing. We need to be alert to the potential impact on monetary policy of the effect of uncertainty on financial markets, as well as the effect of actual negative outcomes. ▪ A moderate fiscal stimulus adding ¼ pp to growth in 2018 and 2019 would be the difference between  

growth slowing to trend and remaining above trend. With no fiscal stimulus package, potentially somewhat slower core inflation in 2018, and growth nearer to trend, a third rate hike in 2018 would be less likely. 

▪ The possibility of an impending default or an actual default—whether on U.S. debt or other payment obligations—would have severe potential consequences for financial markets and could delay the announcement of the phasing out of reinvestment after the September meeting. A steady hand only goes so far. 

The Outlook Context 

The discussion of the outlook will again be dominated by discussion of the source of the slowdown in core inflation and whether recent readings suggest a decline in the underlying rate and, potentially, a slower return to the 2% objective. At the heart, this is a question of the degree of confidence in the Phillips curve-based projection of inflation moving to 2% as early as next year. In addition, there are signs that momentum in the economy may be slowing, concerns driven principally by disappointing readings on consumer spending. But the fundamentals underpinning household spending remain favorable.  

Just A Price Level Shock or Slower Underlying Inflation?  

Let’s start with the facts! Core PCE inflation on a 12-month basis has slowed from a recent high of 1.8%,  where it was as recently as February, to 1.4% in May. On the surface this has wiped away any sign of progress toward the 2% inflation objective over the last year and a half, defying the Phillips curve-based projections of a gradual upturn toward 2% as early as next year. 

Not so fast! The Phillips curve model is about fundamentals, and policymakers recognize—but typically look through—a temporary shock to inflation associated with a one-time price level shock. That affects inflation in the near term but not the inflation forecast after that shock has passed through. In this case, a sharp decline in the price level of wireless communications services has subtracted about three tenths from the 12- 

month core PCE inflation rate. That would mean we should add three-tenths to estimate the underlying rate of inflation, bringing the underlying rate from 1.4% to 1.7%, consistent with the view that underlying inflation has moved to about 1¾%, well on the way to the 2% objective. That is the dominant view on the Committee. 

The alternative perspective of those more skeptical of inflation forecasts based on the Phillips curve is that this slowdown in inflation may simply be another instance of FOMC participants over-predicting inflation,  reinforcing their concern that core inflation may not be firmly on a sustained upward path and heading toward  2% in the medium term. 

In the end, there is really not much of a policy-relevant difference between the two camps. Those who focus on the one-time price level shock appreciate that there could be something more going on and that that shock might only partially explain the sharp slowing in core inflation. Even those who are more skeptical of the  Phillips curve recognize that there is some temporary effect coming from a price level shock at work. Both camps will hope that the data will resolve this question over the next few months before the third rate hike of the year. 

Labor Market Continues to Improve 

The labor market continues to improve, with continued strong job gains in June and, notwithstanding a one-tenth uptick in June, an unemployment rate that appears to still be on a declining trend, falling further below the NAIRU. In addition, the uptick in the unemployment rate was accompanied by a tenth rise in the participation rate, perhaps a sign of an improving labor market. With the 12-month change in average hourly earnings remaining at only 2.5% in June, wage growth appears to be defying all the other signs of a tighter labor market. 

Is Growth Losing Some of its Momentum? 

The economy still appears to be tracking close to a 2% growth rate. But while Q2 growth is estimated to have rebounded, as expected, it looks weaker than we had expected, and would leave first-half growth a tick below 2%. In addition, while consumer spending appears to have rebounded in Q2, the trend in the monthly retail sales data suggests less momentum in consumer spending into Q3. But the underlying fundamentals 

appear favorable: rising household net worth, balance sheets in good shape, consumer confidence still high,  though down slightly from recent highs, and strong employment growth-boosting labor income. 

Notwithstanding the weaker momentum in consumer spending, the condition that “the economy evolves broadly as anticipated” for phasing out reinvestment appears likely to be satisfied by September, especially given the continuing improvement in the labor market. 

Fiscal Stimulus Still in Our Forecast 

The prospect of fiscal stimulus has been diminishing and, with that, fewer participants are including it in their projections, and those who did include it have trimmed the size of their assumed fiscal packages. We have retained our assumption of a fiscal package that contributes to growth beginning in 2018. This difference in assumptions likely accounts for our forecast being about a ¼ percentage point higher in 2018 and 2019 than the median projections of FOMC participants in June. 

FOMC Call 

No rate hike at this meeting and no announcement of the phasing out of reinvestment. Just talk during the meeting and, of course, the communication through the statement at the end. 

Fiscal Uncertainty and Potential Events Could Affect September Decision 

There are three fiscal issues that monetary policymakers have to worry about. The first is whether or not there will be a fiscal stimulus in 2018 and, if so, how much. The second is whether or not there will be a  government shutdown and, if there is, when it might occur and how long it will last. And third, whether a  government default is a real possibility. 

Monetary policymakers can be expected to respond to any meaningful fiscal stimulus, but the size and timing of that response are open to question. Three hikes next year would be less likely if there is no fiscal stimulus,  as growth would be lower, perhaps close to the trend, and our forecast for inflation next year has already been revised down to 1.8%. If the economy is losing momentum and inflation doesn’t firm as expected, two hikes would be more likely next year. 

A temporary shutdown is not a material macro story. The level of activity falls during the period of the shutdown but bounces right back when the shutdown ends. And because the lost income of government workers is almost always restored, there are not even any meaningful knock-on effects from a shutdown.  Hopefully, the FOMC will demonstrate that it is one institution that is carrying out its responsibilities and do what would otherwise be appropriate. 

The possibility of default is a matter of much greater concern. The state of financial markets in September will certainly be factored into the FOMC’s decision at that time. One could envision considerable uncertainty and volatility in markets if Congress is seriously flirting with the possibility of default, and that would be an environment in which the Fed might be reluctant to begin to put government securities back into the market.  

Could the FOMC Announce a Phasing Out of Reinvestment Next Week? 

We mention this possibility because the discussion in the minutes and some remarks by Governor Brainard at a conference at the New York Fed suggested to some that there was some support among participants for an announcement earlier than September. The reasoning for an earlier announcement is principal that the 

fiscal uncertainties discussed above could weigh against a policy decision in September. That’s why there has been speculation about July as a possible time to announce the start of runoff. Our view: Not a chance! 

Rule number one has been: No surprises, period! The FOMC has done an excellent job of informing the markets that an announcement will be made “relatively soon” and the markets already know all the details about how the phasing out of reinvestment will proceed, at least for some time. The market likely has strong expectations for the size of the balance sheet, based on expectations that the Committee will choose to retain the current operating framework. 

While a few FOMC participants might prefer July, and a few might prefer an announcement later than  September, we see the consensus overwhelmingly favoring September, which also has a prescheduled press conference. July would be a surprise, which is what the FOMC has worked so hard to avoid. 

Our Call Remains an Announcement in September and a Third Rate Hike in December 

The data conditionality for an announcement of the phasing out of reinvestment in September is quite modest.  Rate normalization is already “well underway,” meaning high enough to not stand in the way of an announcement. While the slowdown in core inflation increases the uncertainty about the outlook, this will not be a consideration with respect to the timing of the announcement.  

On the other hand, the slowdown in inflation has lowered the probability that there will be a third hike of the year in December, but we continue to believe the data will show somewhat stronger core inflation between now and then, the labor market will continue to improve, and growth will track near 2%, supporting a strong consensus to raise rates at that time. 

The Message in the Statement 

Once again, the Committee will have to wrestle with the language on what it learned about inflation since the last meeting (given that the 12-month rate for core PCE inflation declined again) and what to say about inflation going forward (given that the 12-month core PCE measure will likely be below 2% well into 2018). 

That the labor market continues to improve is a staple of recent statements and will be repeated. The FOMC  will also find a way of emphasizing that the unemployment rate has declined in recent months, as the June uptick in the unemployment rate is a non-issue. The economy will continue to be described as growing moderately. The one change called for in the discussion of labor market conditions in the first paragraph is to  the language on job gains, taking out “have moderated” and simply noting that they “have been solid.”  Household spending appears to have slowed relative to expectations in recent months but is still firmer than  in the first quarter, so we expect the language will simply read “continued to expand.” 

More uncertainty surrounds whether and how the Committee might adjust its language about inflation. In the  June statement, the Committee recognized the slower pace of core PCE inflation, referring to it as “somewhat  below” 2%, but did not qualify that by saying “in part due to transitory factors.” This time, given that core  inflation, is more than ½ percentage point below 2%, we expect the Committee might drop the “somewhat”  qualifier, and we also expect they will refer to “transitory factors.” The “in part” qualifier is important because,  while most participants believe that the underlying rate of inflation isn’t necessarily lower, there is some unease about whether there is more going on.  

The June statement also said that the Committee expected core PCE to remain “somewhat below 2% in the  near term.” The Chair has emphasized that the 12-month core PCE inflation rate is almost surely going to remain well below 2% until the 12-month window no longer includes the recent price level shock. But 

the “somewhat” softens the message slightly and seems to fit better in the second paragraph (forward-looking) than the first (the state of play today).  

As for policy discussion in the statement, the Committee might want to signal that an announcement of the  phasing out of reinvestment is imminent (meaning September), rather than just “this year.” It could signal  September more strongly as the likely timing by replacing “this year” with “soon” or “relatively soon,” wording that some FOMC participants have used in their public remarks in describing their personal views. “Soon”  would point to September more decisively, but the FOMC might think that the extra little conditionality afforded by “relatively” might be prudent given the fiscal uncertainties and market turbulence they could confront in September. Which words they choose here will not affect our call for a September announcement,  even if the wording remains “this year.” 

Our Guess of the July FOMC Statement 

Information received since the Federal Open Market Committee met in June May indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.  Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined, on the net. Household spending has picked up in recent months, and business fixed investment has continued to expand. On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent, in part due to transitory factors. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance. 

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 raise 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. 

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 currently expects to begin implementing a balance  sheet normalization program this year relatively soon, provided that the economy evolves broadly as 

anticipated. This program, which would gradually reduce the Federal Reserve’s securities holdings by decreasing reinvestment of principal payments from those securities, as is described in the accompanying addendum to the Committee’s Policy Normalization Principles and Plans released at the time of the June  FOMC statement. 

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. Voting against the action was Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate. 

Market Response 

We don’t expect much of a market response if the statement comes out as we expect. However, if the  Committee were to leave out the “somewhat” in the second paragraph, saying that inflation is expected to remain simply “below” 2% in the near term, there might be a decline in longer-term yields and some pricing out of a December hike. 

Dissents 

Can’t see a reason to dissent at this meeting. Any disagreement is not likely to be intense enough to warrant a dissent. Although President Kashkari prefers a lower level of the fund’s rate, his approach to dissenting appears to be to formally dissent at meetings at which the FOMC raises rates.

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