Economist's Insights

July 26, 2017 FOMC Meeting Minutes – Fed Divide on Inflation Raises Bar for Incoming Reports

Aug 17, 2017

The Minutes from the Fed’s July meeting confirmed the growing divide between Committee members that has become evident in recent Fedspeak. There was basic agreement on the recent trends in economic activity and general outlook for activity over the near-term. With respect to the Fed’s mandates, the Committee appears comfortable with the level of hiring and the notion that the labor market is nearing, if not at, full employment. With the labor market continuing to produce stronger-than-expected hiring and an unemployment rate that has persistently run below the Fed’s projected longer-run rate, all eyes shifted to the turn lower in the recent inflation readings.

There were two paragraphs within the Minutes dedicated exclusively to the inflation topic. The first described the divided opinions. On the more hawkish side of the divide, “Many participants noted that much of the recent decline in inflation had probably reflected idiosyncratic factors.” In contrast, “Many participants, however, saw some likelihood that inflation might remain below 2 percent for longer than they currently expected.” Within those more concerned about inflation, “several indicated that the risks to the inflation outlook could be tilted to the downside.”

The second paragraph showed the Committee’s search for answers. The Minutes showed that “most” still trust the Phillips Curve. The Minutes listed several reasons why inflation might by running lower than expected: (1) a weaker relationship between unemployment and wage growth, (2) lower natural rate of unemployment, (3) improperly measured labor slack, (4) a longer lag within the Phillips Curve, and (5) globalization and technology. Despite the lack of answers, where the Fed lands on this so-far unanswerable question holds the key for future Fed rate increases.

As to the policy outlook, those that were more concerned about inflation believe the recent weakness will allow the Committee to be more patient with the policy rate. These members believe that before raising rates again, more data is needed to confirm that inflation is firming. On the other hand, there are those that believe the current and expected strength of the labor market warrant further gradual tightening to avoid an inflation overshoot.

On the balance sheet, there continues to be consensus support for beginning normalization “relatively soon”; recent Fedspeak has confirmed the markets’ expectation of September timing as reasonable. At the July meeting, there were several who supported announcing a start date in July. However, “most” wanted to wait for an “upcoming meeting.”

Bottom Line: Barring any significant, unforeseen financial or economic shocks, a September announcement of the commencement of the Fed’s balance sheet normalization plan appears to be the base case. As to the timing of future rate hikes, the answer lies in future inflation data. With the Committee evenly divided on the cause of inflation weakness in 2017, the bar has been raised for the incoming inflation reports to show the trend moving towards the Fed’s 2% target.