The Minutes to the May FOMC meeting released this week reiterated increased confidence in inflation stabilizing near two percent and diminished downside inflation risks, as well as confidence in expectations of above-potential medium-term GDP growth. Most Fed participants judged that another policy rate hike would be appropriate soon—a nod to a June rate hike that is widely expected.
The Fed for the most part continued to project a smooth monetary policy path, but near-term policy decisions may be more difficult than it currently expects given the mix of economic momentum, higher inflation and a low unemployment rate.
The Fed credited its increased confidence in the inflation outlook to the pick-up in headline and core personal consumption expenditures (PCE) inflation to 2 percent and 1.9 percent, respectively, and continued above-trend real GDP growth.
The Fed is making a concerted effort to highlight the symmetry of its two percent inflation target by stressing a willingness to allow inflation to exceed two percent, especially because it has been below two percent for a prolonged period. The document stated,
“It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee's symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.”
The Fed will have to explain what exactly “temporary” and “modestly” mean when describing inflation above two percent. Will the Fed be comfortable with inflation running above two percent for months, quarters or years? And by modestly above two percent does the Fed mean inflation in a 2 to 2.5 percent or 2 to 3 percent range? A more precise framework is required given the progress on inflation towards two percent this year.
There were a few distinct views on the risks surrounding the inflation outlook:
1) Some participants thought that tightening resource utilization and supply constraints would “intensify” wage and price pressures.
2) A few believed that survey-based inflation measures and market-based measures of inflation compensation remain low and suggest that inflation near two percent may not be sustained.
3) Some thought that continued healthy labor market performance and resulting increase in labor supply would cause less intense upward pressure on wages and prices.
My expectation is for core PCE inflation to rise to two percent in Q3, and exceed two percent on a sustained basis in 2019. But the risks to underlying inflation are to the upside based on sustained healthy labor market performance and solid economic momentum. Headline PCE inflation will be boosted by the run-up in energy prices in the near-term, but the Fed will look past this energy-induced boost to prices, and focus on the core.
In the Fed’s latest Summary of Economic Projections, the median expectation was for core PCE inflation to remain below two percent at year-end 2018, but based on stronger-than-expected inflation thus far in 2018, Fed participants will likely bump up core PCE inflation forecasts at the June meeting. And of course, based on the run-up in energy prices, they will be forced to increase their forecasts for headline PCE inflation.
The Fed continued to express confidence in a Q2 GDP growth rebound. It cited fiscal policy, optimistic business and consumer sentiment, and supportive financial conditions as supporting the solid outlook. The Minutes noted that, although business contacts were optimistic, uncertainty over global trade policy had the potential to cause a postponement or pulling back of capital expenditures.
An extensive discussion occurred about the flattening of the yield curve. Several participants viewed the yield curve as valuable in predicting recession, while a few noted that special factors – gradual policy normalization, large Fed balance sheet, accommodative policy by other central banks, lower estimates of long-run real rates – suggest that the yield curve is probably a less reliable predictor of recession than it has been in the past.
By my estimates, based on the current yield spread (10-year Treasury yield minus 3-month yield), the probability of recession unfolding 12 months from now remains below 11 percent.
The Minutes did not reveal any explicit discussion about the total number of policy rate hikes that participants expect this year, but public comments from various Fed officials continue to point to a fairly even split between those expecting three total hikes and those expecting four. Based on the economic and inflation outlook, it is unlikely that the Committee will pause its policy normalization during any quarter this year and continue to expect a total of four hikes.
The Fed will probably face challenging near-term policy decisions if the economy continues to grow above potential, core inflation exceeds two percent, and the unemployment rate remains well below estimates of “full employment” and falls further. The Fed’s reaction function when inflation actually exceeds two percent on a sustained basis may be different than it currently projects.
The Fed continued its discussions on possible changes to forward guidance if it normalizes policy as projected and policy should transition out of an accommodative stance to neutral or tight. It noted that changes could be made to the following phrases in its policy statement after a few more rate hikes: "federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run," and "the stance of monetary policy remains accommodative."
The Minutes revealed no substantive discussions about the Fed’s balance sheet policy. If inflation were to exceed expectations, the Fed should consider moving more aggressively on its balance sheet policy rather than more aggressively raising rates, especially given the yield curve flatness.
Mickey Levy is the chief economist for the Americas and Asia of Berenberg Capital Markets, LLC, and member, Shadow Open Market Committee.
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