Going into this meeting, we said the main thing we’d be looking for was how Chair Powell, in his press briefing, characterized the outlook for inflation given the recent soft inflation data. His comments indicated little concern about too-low inflation and suggested that there is unlikely to be a cut in rates in the near term, at least on this basis alone.
Powell emphasized over and over that policymakers do not expect this softness to persist and that core inflation is expected to return to near 2%. He noted that the Dallas Fed’s trimmed mean measure remains at 2%. He pointed out that softness in specific components—such as portfolio management services, airfares, and apparel—contributed importantly to softness in overall core prices. He cited the example of telecommunications prices weighing on core measures in 2017, after which core inflation rose to 2% as the FOMC predicted. This was about as strong a defense of “looking through” below-target inflation as we could have expected from Powell.
So what would concern the FOMC? Powell emphasized repeatedly that the FOMC would be concerned if core inflation were “persistently” below 2%, but he didn’t indicate explicitly what would qualify as a “persistent” shortfall. While it appears that this remains an open question among FOMC participants, Powell’s comments did provide some insight into a reaction function. He noted that core inflation was near 2% for much of 2018 and has only recently dipped below 2%. So, at least for meeting this criterion of persistently below 2%, Powell suggested that the shortfall for so many years prior to 2018 doesn’t count.
Powell’s remarks also suggested, not surprisingly, that the FOMC is not thinking in terms of strict thresholds for 12-month core PCE inflation that would require an easier policy. Policymakers care about the trend and the outlook: “Inflation, first of all, month to month, quarter to quarter, is going to move around. There will always be factors hitting it so probably the biggest single factor driving it is the rate of underlying inflation or a closely related idea of where inflation expectations are anchored, the thought being that’s where inflation will push.” Even if core PCE prices grow at a 2% annualized rate going forward, the 12-month rate will be at 1.5% for several months and then at 1.7% through December 2019, only reaching 2% in March 2020. As in 2017, the FOMC appears to be comfortable with the 12-month rate remaining below 2% for some time if the pattern in monthly price changes indicates an underlying trend near 2% and a credible forecast back to 2%.
Moreover, when pressed to clarify how monetary policy would respond if core inflation were to continue to come in soft relative to expectations, Powell noted that inflation is only one part of the mandate and that there are a number of variables that go into monetary policy decisions: “You know, ultimately, there are many variables to be taken into account at a given time, but that’s part of our mandate, stable prices are half of our mandate and we’ve defined that like 2 percent so we would be concerned and we would take it into account.” Powell clearly didn’t want to add to speculation about an easing. And he clarified that the FOMC’s current disinclination to ease policy is not related to financial stability concerns: “I’d say that the headline really is that while there are some concerns around nonfinancial corporate debt, really the finding is that overall vulnerabilities, financial stability vulnerabilities, are moderate, on balance, and in addition, I would say that the financial system is quite resilient to shocks ever various kinds with high capital and liquidity.” The message
at this point seems to be that a forecast that inflation will return to 2% remains good enough—at least as long as inflation expectations are stable. The FOMC is not inclined to ease on this basis anytime soon.
Although we expected the recent strength in the effective fund’s rate to motivate a further 5 -basis-point downward adjustment to the IOER rate, it was a bit surprising that the Fed opted to make the adjustment so soon. Powell underscored the Fed’s commitment to keeping the fund’s rate trading within its target range and emphasized that they were learning from experience what the real demand for reserves is. He also left the door open to the possibility of another IOER adjustment.
Powell noted that the size of the balance sheet will be “Driven by financial stability.” He said there was “no template, no roadmap,” signaling that the Fed has made no conclusions about the ultimate level of reserves. He cited the newly tapered roll-off rate for Treasury securities as an example of their gradual approach. The urgency of the adjustment to IOER makes us think it is quite possible for a deterioration in liquidity conditions to bring about a premature end to balance sheet reduction and perhaps an earlier start to outright purchases of Treasury securities to offset the general decline in reserves resulting from growth in non-reserve liabilities. Powell noted that “adjustments to the balance sheet normalization process may well be needed as the process unfolds.”
Although the New York Fed said they would provide more details on the maturity composition of MBS reinvestment Treasury purchases at this meeting, Powell said they will return to the maturity composition question toward the end of the year. Powell also noted that the FOMC will explore the merits of other tools to control short-term interest rates, such as a repo facility, at upcoming meetings. He did not respond to multiple questions about whether the Fed would switch to targeting a different benchmark rate (such as IOER or OBFR).
All the substantive changes to the statement were in the first paragraph, and they were about as expected. Nothing changed our views on the outlook for monetary policy.
▪ The most notable change was to the inflation language. It was noted that, on a 12-month basis, both headline and core inflation “have declined and are running below 2 percent.” The FOMC did not elaborate on the reasons for the decline, however, and the second paragraph continued to state that “The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes.”
▪ Growth was described as having risen at a “solid” rate. We thought the 3.2% real GDP growth in Q1 qualified as “strong,” but no matter.
▪ Payroll gains continued to be described as “solid, on average, in recent months.” ▪ Growth of household spending and business fixed investment was described as having “slowed” in the first quarter, and no qualification was given.
▪ The language on inflation expectations remained the same. Survey-based measures were “little changed.” Market-based measures “have remained low in recent months.”