Minutes Show Most Fed Officials Expected Gradual Rate Increases to Continue, Ongoing Debate about Inflation
by Craig Dismuke, Dudley Carter
The December Minutes showed most participants and almost all voting members expected continued gradual rate increases to continue. However, there was a lengthy paragraph’s worth of discussion of what “gradual” means and what could cause reality to be diverge from current expectations. As to the current projected path, a few believe it is too aggressive and could cause inflation and inflation expectations to remain below target. However, a few others believe it isn’t aggressive enough since overall financial conditions remain easy and unemployment remains below the projected NAIRU rate. There was also pondering about possible events that could result in a faster or slower pace of rate increases over the forecast horizon. The Minutes noted that if inflation pressures were to surprise to the upside, “perhaps owing to fiscal stimulus or accommodative financial market conditions”, the Fed may have to hike faster than they currently expect. Conversely, if actual inflation or future expectations do not show an improvement back towards 2%, it could cause the Fed to move more slowly.
On Economic Activity and Fiscal Stimulus
The rationale for the Fed’s stronger GDP outlook was easy to find. The Minutes showed that “Most participants indicated that prospective changes in federal tax policy were a factor that led them to boost their projections of real GDP growth.” Fed members said the current solid pace of activity was being driven by “gains in consumer and business spending, supportive financial conditions, and an improving global economy.” These driving forces could be strengthened by the recently-passed – still an open item at the time of the December meeting – tax cuts. For individuals, many expected “some boost” to personal consumption because of the cuts and a few noted some consumers may have already spent some of their future savings. For businesses, many Fed officials expected a “modest boost to capital spending” but there was some discussion of business contacts indicating tax savings could be used for M&A or share buybacks. If businesses do invest their savings in capital projects, the Fed noted it could “contribute to positive supply-side effects, including an expansion of potential output over the next few years.”
On the Dual Mandate
The Fed noted payroll gains were “well above a pace consistent with maintaining a stable unemployment rate over time” in recent months and rattled off several other indicators that signaled the continued tightening of the labor market. While many believe this will eventually lead to higher wages, the current results are mixed according to the anecdotal evidence included in the Minutes. A scarcity of labor resources is leading some business contacts to raise wages while some others are offering other non-wage benefits to attract employees. More broadly, many Fed officials expected continued strengthening in the labor market to nudge inflation higher over the medium-term and believe some transitory forces applying downward pressure will also fade. However, some acknowledged the possibility that it may take longer than expected to achieve the 2% target. On net, the full participant group saw the medium-term outlook for inflation as little changed.
On Financial Markets
Some Fed officials believed overall financial conditions (e.g. low interest rates, tight credit spreads, elevated stock prices, weaker Dollar) remained accommodative. While this was one of the contributors to the solid pace of economic activity, it also led a few to be concerned about possible risks to financial stability. The flattening of the yield curve was allotted a full paragraph, with the conclusion being a general agreement that the current shape was not unusual for this stage of a cycle. It was not completely written off as a non-event however, with several indicating it would be an important data point to watch and others going so far as to highlight it as a concern.
Bottom Line: When the Fed met in December, before the tax cuts were signed into law, the consensus was for additional gradual rate increases in 2018 and beyond. There was also a belief that tax cuts could boost spending by consumers and businesses and potentially cause the Fed to hike faster than expected. However, there continued to be considerable uncertainty about the outlook as evidenced by the debate about the legitimacy of the projected rate path and risks that could cause the Fed to move faster or slower than they expect. In addition to the upside risks from tax cuts, financial stability risk continue to drive some to support tightening. However, with inflation below target and inflation expectations subdued, others fear that hiking too much could be a mistake. As expected before the Minutes, the inflation metrics will be key to determining the policy path for 2018. The continued lack of clarity could be seen in the market’s response. Treasury yields and the Dollar initially jumped but quickly fell back to unchanged while stocks held on to earlier gains.