Several policymakers drew attention to financial stability concerns last week, although they concluded that the current situation warrants monitoring rather than any immediate action. Yellen noted that “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations, and those ratios ought to depend on long-term interest rates.” She added that the financial system is now “much safer and much sounder” and “the architecture of the system has changed in important ways that make it safer.” But to say there won’t be a financial crisis in the future is “probably going too far.” She revealed that the Fed now will “talk to people in different pieces of the financial sector about all of the things that could conceivably go wrong that are not in our models.” (Jun 27) Fischer said that, “overall, a range of indicators point to vulnerability that is moderate when compared with past periods,” but he warned that “the increase in prices of risky assets in most asset markets over the past six months points to a notable uptick in risk appetites.” He believed that “the evidently high risk appetite has not lead to increased leverage across the financial system, but close monitoring is warranted.” He cautioned that “We know that complacency must be avoided” (Jun 27).
Williams was also concerned about “complacency in the market”: “If you look at these measures of uncertainty, like the VIX measure, or other indicators, there seems to be a priced-to-perfection attitude out there.” He also observed some risky behavior: “We are seeing some reach for yield, and some, maybe, excess risk-taking in the financial system with very low rates. As we move interest rates back to more-normal, I think that that will, people will pull back on that.” As for equities, Williams was worried about excessive valuations: “The stock market still seems to be running very much on fumes, or is very strong in terms of that, so something that clearly is a risk to the U.S. economy, some correction there, is something that we have to be prepared for, and to respond to, if it does happen.” However, he was not worried about spillover to the broader economy yet: “The U.S. economy still is doing — I think on fundamentals — is doing quite well. So I’m not worried about some kind of late-’90s, dot-com bubble economy where a lot of the underpinnings were driven by the stock market” (Jun 27). Dudley also referred to current financial conditions in his argument for continued policy normalization: “For example, when financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened. On the other hand, when financial conditions ease — as has been the case recently — this can provide additional impetus for the decision to continue to remove monetary policy accommodation” (Jun 26).
Policymakers continued to confirm our expectation that a runoff announcement would most likely occur at the September meeting (see our analysis for more details). Bullard argued against a July announcement: “I think it’s more prudent to announce balance-sheet adjustment at a press conference meeting. So September is more likely”. He did not believe runoff would have a significant impact on financial markets as it has no “signaling effect” (Jun 29). On whether the level of the funds rate provided enough cushion to begin balance sheet normalization, Harker stated: “I believe we are there” (Jun 27). Likewise, Dudley pointed to the muted financial market response to balance sheet news as suggesting “that these communications have generally been effective in fostering an orderly adjustment in expectations about how we are likely to normalize our balance sheet” (Jun 26).
The inflation outlook continued to weigh on some policymakers. Bullard reiterated his concern: “U.S. inflation and market-based inflation expectations have surprised to the downside in recent months. Low unemployment readings are probably not an indicator of meaningfully higher inflation over the forecast horizon…Recent inflation data have surprised to the downside and call into question the idea that U.S. inflation is reliably returning toward target” (Jun 29). Likewise, Kashkari saw no urgent impetus for further policy tightening: “Since we aren’t seeing inflation coming up to our target, let alone getting to high levels, basically I’m saying what’s the rush, why are we trying to cool down the economy” (Jun 27).
Other participants were more upbeat on the inflation outlook. Williams observed real wage growth surpassing productivity growth–a “sign of a stronger economy”–and characterized the labor market as “hot”: “We are seeing signs that as the labor market gets tighter in the U.S., that wage growth is picking up” (Jun 28). He expected the 2% objective to be reached “in the next year or so,” and emphasized “we’re not alone in this improving outlook. When you look at the economic news coming out of Europe and Japan, for instance, you see economic indicators moving in the right direction” (Jun 27). Harker conceded that it’s “possible we are entering a low-inflation world.” However, that was not his base case: “I do not believe the Phillips curve is dead forever. I do not think the relationship between unemployment and inflation is broken. It’s still there, it’s just changed. When it will reassert itself, I can’t tell you…I’m an optimist that investment will increase to raise productivity but that won’t happen overnight.” He was “starting to see some wage pressure but it’s not across all sectors” and shifted his inflation outlook “slightly on meeting our inflation goal from the end of 2017 to the beginning of 2018.” He concluded, “I’m still in favor of another rate rise this year. But if we start to see inflation move away from the goal, we may revisit that” (Jun 27).
Yellen said that there are reasons for interest rates to remain low “for quite some time.” She said “what we would worry about would be if inflation expectations were slipping,” which would make lower inflation “endemic and ingrained.” She noted that inflation expectations aren’t giving a “consistent story” and it’s unclear which indicators “actually matter.” (Jun 27)