The January FOMC minutes portray a Committee wrestling with a more uncertain economic and policy outlook due to tighter financial conditions, indications that inflation will be held down for longer than previously anticipated, possible headwinds to growth from global developments and conflicting signals from the US data flow. Committee participants are clearly aware of the negative impact that tighter financial conditions can have on growth, but remain uncertain about whether the recent tightening in conditions will persist. As such, they concluded that it was too soon to alter their medium-term economic outlook based solely on recent financial market developments. Still, participants appreciate that a sustained tightening of financial conditions “could be a factor amplifying downside risks” and would be “roughly equivalent” to the effects of “further firming in monetary policy”.
The discussion on the inflation outlook also evidenced greater uncertainty, as well as an appreciation of downside risks. Most tellingly, it appears that fewer participants are confident that inflation will return to the two percent objective over the medium term. In the December meeting minutes, “nearly all” participants held this expectation, while only “most” participants expressed this view at the January meeting. Granted, the difference between “nearly all” and “most” may be no more than two or three Committee participants, but is indicative of growing uncertainty about the inflation outlook. Recent declines in survey measures of inflation expectations and market-based measures of inflation compensation may underlie the less certain inflation outlook. In particular, some participants took note of the decline in survey-based inflation measures to historically low levels. While these surveys have come in for discussion in the past, the January minutes indicate somewhat increasing concern over their current low readings, which could indicate a growing risk that inflation expectations will become unanchored from the Committee’s two percent objective.
The Committee discussion also revealed a greater appreciation of the risks posed by commodity price declines and slowing growth in emerging markets. Prior Committee discussions on the effects of low oil prices tended to focus almost exclusively on the benefits to consumers. By contrast, in the January meeting participants discussed how commodity market developments could “restrain domestic economic activity” through their effects on individual firms and countries that are significant commodity producers. Similarly, Committee members were less sanguine than in the past about the global growth outlook and its impact on the US economy, particularly as relates to China. In the past, Committee members had focused on the relatively limited direct exposure of the US economy to China through trade. In contrast, the minutes revealed concerns “about the potential drag….from the broader effects of a greater-than-expected slowdown in China and other EMEs”, such as economic and financial stresses in commodity-producing countries.
Conflicting signals in the U.S. economic data constituted a final source of uncertainty at the January meeting. Committee members took some pains to square the strength in the labor market with disappointing growth and consumption data for the fourth quarter. In addition, Committee members also picked up on some of the same signals from the service sector as appeared in the January non-manufacturing ISM survey. At the December meeting, participants described business activity outside of those sectors affected by low energy prices and weak exports as “solid”. In contrast, at the January meeting, “Several participants reported moderate growth in services industries”, and “Information on business activity outside of the manufacturing sector was mixed.”
All of the above sources of uncertainty played into the Committee’s decision to refrain from characterizing the balance of risks to the outlook in the January meeting statement. In addition, “several” participants noted that “waiting for additional information regarding the underlying strength of economic activity…before taking the next step to reduce policy accommodation would be prudent”. This sentiment is in line with my own thinking – despite the rally in risk assets in recent days, financial conditions are unlikely to ease substantially in the coming months. In addition, the service sector has lost some momentum, and banks show signs of tightening credit standard for commercial and industrial loans. These factors, along with very low survey measures of inflation expectations, underlie my current thinking that the Committee is likely to hold off on raising rates further until the second half of the year, as it looks for signs that growth will remain above trend and that inflation is beginning to show sustained progress towards the two percent objective. Please look for a note from me in the coming days that explores this topic more thoroughly.