We saw three themes in remarks of FOMC participants last week. Most of the speakers saw at least one hike as likely appropriate this year, based on initial conditions—basically at full employment and confidence inflation headed to 2%—and a relatively optimistic forecast. The “show me the inflation” camp was not well represented last week, but their voices will be heard at the September meeting. Second, while the pace of rate hikes is likely to be very shallow, the market is pricing in too few rate hikes between now and the end of 2018. Third, the prevailing low r-star is an enormous challenge for monetary policymakers who must adapt their monetary policy frameworks to the new reality.
Lockhart, Williams, and Fischer continue to focus on proximity to full employment and progress toward price stability. For example, Lockhart said “I think it is fair to say we are closing in on full employment” and “Recent price data hint at the firming of underlying price pressures. I’m reasonably comfortable with a forecast of reaching 2 percent by year-end 2017.” Williams, in basic agreement, was more forceful. He said “We’re at full employment” and “inflation is well within sight of, and on track to reach, our target.” Fischer said that, even at 1.6% core PCE inflation over the last year, inflation is “within hailing distance of 2 percent” and that “we are close to our targets.” Dudley, on the other hand, continues to be less convinced about inflation, saying “the underlying trend of inflation has been pretty flat over recent months. So in my mind the inflation outlook really hasn’t changed very much.” And even Williams said he would like to see data continuing to firm to provide more support for his expectations with respect to inflation.
When Dudley was pressed in an interview about whether a rate hike in September was possible, he said: “[Yes], I think it’s possible.” Without being pinned down about September, he said: “I think we’re getting closer to the day where we’re going to have to snug up interest rates a little bit.” Lockhart and Williams were more hawkish. Lockhart said that, “if my confidence in the economy proves to be justified, I think at least one increase of the policy rate could be appropriate later this year.” Williams said, “In the context of a strong domestic economy with good momentum, it makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later.” Fischer did not comment on the timing of the next rate hike.
With respect to market pricing, Williams warned that the market might be underpricing the likelihood of rate hikes in the near term: “What worries me a little bit more is that there is a view out there [that] no matter what the Fed says they are not going to raise rates for a year or two…That’s inconsistent with my understanding of the economy and also the strategy that we’ve laid out.” Dudley echoed Williams’ view: “[The futures market] has basically one rate hike priced in through the end of 2017. I find that, you know, too low. I think the market is complacent about the need for gradually snugging up short-term interest rates over the next, you know, year or so.”
In a good setup for the Jackson Hole conference, Williams published a policy note in which he argued that the time has come to “reassess prevailing policy frameworks…specifically those related to a low natural real rate of interest.” He floated two options: pursuing a “somewhat higher” inflation objective and moving from an inflation objective to a flexible price-level or nominal GDP targeting framework. Bullard continued to talk about two regimes: a prior high-growth, high-r-star regime, and today’s low-growth, low-r-star world. Policy must be regime-consistent. Fischer also noted a “concern” about declines in estimates of r-star and specifically the implication that short-term rates might be more frequently constrained by the effective lower bound.