Fundamental Macro

The January FOMC minutes were unusually long. In addition to the usual annual update of the longer-run goals of monetary policy strategy (which were essentially unchanged from last year, except to reflect new central estimates for the NAIRU), the minutes also contained a further technical discussion on tools for policy liftoff. There are some interesting points to reflect on here so they will get their own post. For now I will restrict myself to the Committee’s views on policy and current conditions.

Policy: should I stay or should I go?

The usual list of risks to tightening too late or too early were trotted out again:

On the risks to too late:

1. Inflation rising too high as result of overly loose policy
2. Financial stability (both from being too low for too long and from having to hike aggressively)
3. Embedding expectations that rates would rise more slowly than reasonable once they did start hiking

On the risks to too early:

1. Damp the apparent solid recovery
2. Increase the risk of hitting the lower bound again should an adverse shock come along [not obvious to me how this is particularly worse than already being at the lower bound when an adverse shock comes along]
3. And a new one – the communications challenge of hiking when headline inflation is so far from 2%

But it was the first sentence of the following paragraph that garnered all the attention:

“Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time.”

The common interpretation was that this was taking a June hike off the table, and the ED strip rallied accordingly. BUT…I was less convinced that this was the intention they wanted to convey. The language does not make any reference to time, in particular, it does not say that this was a shift in views from, say, the previous meeting. Indeed, as it follows a general discussion kicked off by the staff on the risks, I interpreted it as being entirely consistent with the December press conference language that ruled out the next couple of meetings. So I think June is still on the table, but the hurdle is probably a little higher with the added complication of the how weak the headline inflation prints will be at that point.

Beyond this section, given that the timing of first rate hike has been tied more explicitly to confidence in inflation returning to 2%, the Committee pointed to sufficient pace in the growth of activity to support continued labour market improvement as a key factor. They also pointed to stable or rising [my emphasis] measures of core or trimmed inflation measures. Interestingly, inflation breakevens were somewhat downgraded in their importance, and for some at least, so were wages.

Finally, they couldn’t avoid a brief discussion of “patience”. They are worried removing it will have an adverse market reaction, just as they were concerned about the removal of “considerable time”. And so they will try to make clear it doesn’t necessarily (although could) mean the very next meeting they hike, but probably soon after that. In my view the sooner they get out of this silly word trap the better, and I expect that it will go in March.

FOMC views on current conditions

The Committee’s views on economic activity were largely unsurprising, with the most notable comment affirming the view that the decline in oil prices was a net positive for the US economy. More interestingly, the section on inflation made clearer the view that the impact of oil prices was expected to be temporary. Inflation expectations remained well anchored and the decline in headline inflation was, so far, contained to a relatively narrow range of items, and was therefore not indicative a broader slowing in inflation. This is an important point, and I believe is key to the Committee having a hook to hang the first rate hike on, when headline inflation is likely to be extremely low.

There was some disagreement amongst a minority about the impact of lower inflation on wages, but a longer exposition of the argument previously made by Yellen, that wages might pick up quite rapidly if they have been held back over a longer period than usual due to nominal downward rigidities during the crisis, was more telling. Indeed most continued to expect wage growth to rise and inflation to return to 2% in the medium-term, and those that didn’t thought it would rise more rapidly, and above the 2% objective.

The views on inflation breakevens was pretty muddled. Some think they matter, others don’t. Interestingly some now also question the worth of survey-based measures. So while the Committee will continue to say that they will look at all of these very closely, the reality is measuring inflation expectations is an art as much as a science.

Unsurprisingly the labour market was seen as improving further. A few took the stronger employment gains, with little wage impact as a signal to lower their estimate of the NAIRU. While others suggested that it meant the remaining degree of slack would soon be eliminated. I doubt the core of the Committee was particularly moved either way.

On activity they viewed that it had been expanding at a solid – above trend – pace in Q4 and into January, and that labour market conditions had improved further, diminishing the degree of slack. And while inflation would be suppressed in the near-term due to weaker energy prices, the medium-term view was little changed. Indeed, the Committee regarded the decline in energy to be a net positive for activity and employment. And while many pointed to the downside risks from global growth, several thought that those risks had diminished due to policy action and lower oil prices. An offset, however, was concern about the strength of the USD on export performance.

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The staff review of conditions and updated forecast contained few surprises. The highlights being:

• Solid economic growth in 2014 H2, with particularly robust IP and household consumption in Q4 (the latter being particularly supported by the decline in oil prices and likely associated improvement in sentiment).
• Partly offsetting that was somewhat disappointing investment spending, particularly given the relatively upbeat survey outcomes for the period. Housing activity remained a laggard, but was showing some signs of improvement.
• On the inflation front, unsurprisingly the focus was on the impact of lower oil prices on headline inflation rates, but with core inflation less affected.
• The staff attributed the decline in sovereign yields over the period to a deterioration in market sentiment associated with: downward pressure on inflation, increased concern about global growth, global policy easing, declining oil prices and somewhat disappointing activity data in the US.
• Growth projections were revised up a little in the near-term (reflecting stronger disposable income and consumption growth), but little changed further out as the stronger dollar offset that boost.
• Near-term inflation projection was revised down to reflect the decline in oil prices, but the outlook for 2016 and beyond was unchanged.