Economic Flash: The Fed Can’t Figure Out Inflation Either
by Craig Dismuke, Dudley Carter
At the September meeting, the Fed announced it would begin the process of normalizing its portfolio of Treasury and Agency securities, including mortgage-backed investments, in October. The details of how this normalization process will be executed were earlier released in June and markets had anticipated the October start date. As such, this was a non-event from the market’s perspective when the Fed made the official announcement on September 20. As a result, the big news from the September meeting revolved around the changes, and lack of changes, in the Fed’s updated forward rate projections. For 2017 and 2018, the Fed left its rate forecast unchanged; the Fed still expected one more hike in 2017 and three in 2018. However, in 2019 the Fed projected one fewer, two hikes total instead of three, and lowered the longer-run neutral rate to 2.75%; the Fed had increased the neutral rate to 3.00% in December 2016. With the unemployment rate below the Fed’s estimate of the NAIRU rate, the onus for tighter monetary policy falls primarily on the incoming inflation data. While we’ve heard various officials comment on inflation trends since the Fed gathered in September, the big questions to be answered from the Minutes were (1) what was the general tone of the conversation surrounding inflation and (2) what caused the Fed to leave the near-term dots unchanged but expect one less hike in 2019 and a lower longer run, neutral rate.
What was the Fed’s take on progress towards its 2%-inflation target?
At the highest level, the group of officials who vote on policy this year held the exact same outlook as the full participant group: “Higher prices for gasoline and some other items in the aftermath of the hurricanes would likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis was 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.” However, the Minutes described an in-depth and inconclusive debate about the weakness that has dragged inflation metrics lower in 2017. This discussion mirrors the divide apparent in recent public remarks from various Fed officials.
“Many participants” believed a tight labor market and above-trend economic growth would eventually boost prices and “many” still blamed, at least in part, “idiosyncratic or one-time factors” for the slower price gains. However, there were other factors considered that may be less temporary (“changes to government health-care programs”) and “some participants” went further to say that “secular trends” such as technology’s effect on businesses’ pricing power could have a longer-lasting effect. These feelings led “many” to believe recent downside developments warrant “some patience in removing policy accommodation while assessing trends in inflation.” However, “some patience” obviously meant different things to different officials. “A few” called for no more hikes in the near term and a more shallow forward path. “Some other participants” remained concerned about upside risks to inflation from overshooting full employment and the net easing of overall financial conditions.
As to what this means for near-term rate changes, the net effect left “many” participants to still expect another 2017 hike if their medium-term outlook remained unchanged. A smaller group made up of “several others” said uncertainty surrounding inflation meant the incoming data needed to boost their confidence inflation was headed towards the 2% target. An even smaller group of a “few participants” said they would not support another hike until actual data confirmed “inflation as clearly on a path” to 2%.
What were the dynamics that drove the changes in the dot plot?
There were very few specifics as to why the dots changed (2019 and longer-run) or didn’t change (2017 and 2018) in the September projections. Much can be reasonably implied from the general uncertainty surrounding inflation and the gradual, and potentially more shallow, path detailed in the discussion above. In addition, the discussion surrounding the updated Summary of Economic Projections showed “many participants again expressed” their belief the forward path will be gradual. As to why, those participants cited a low neutral real rate as one of the driving forces of the gradual path. As to the changes from June, “Some participants judged that a slightly lower path of the federal funds rate than in their previous projections would likely be appropriate, with a few citing a slower rate of progress toward the Committee’s 2 percent inflation objective than previously expected or reduced prospects for fiscal stimulus.”
Bottom Line: The biggest group of Fed officials still believed that another 2017 hike would be warranted and consistent with the gradual pace of tightening. This was consistent with the unchanged median dot for 2017. However, there is still a lack of clarity as to what is causing the recent inflation weakness and an evident concern among many in the group that there is more affecting the data than temporary or one-off factors. This uncertainty is consistent with the less optimistic projections for 2019 and the longer-run. The Minutes didn’t seem to alter markets’ expectations or paint a drastically different picture of Fed expectations. Fed funds futures were essentially unchanged (roughly a 75% chance of a December hike) as were Treasury yields and the U.S. Dollar.