June FOMC Preview: Slouching Towards Neutral

11 Jun 2017

In thinking about the monetary policy outlook this year, my approach has been to draw a distinction between the current juncture and the prior two years, when the Committee held off on raising rates whenever data hit a soft spot or financial conditions tightened meaningfully. In contrast to prior years, this year the Committee is much more committed to getting the policy stance closer to a neutral setting, for a variety of reasons:

  • The Committee feels that there is very little slack left in the labor market;
  • At least coming into the year, the underlying inflation trend appeared stronger;
  • Rate increases to date have not succeeded in tightening financial conditions. In fact, financial conditions are now more accommodative than they were in December 2015, when the Committee first raised rates;
  • Global growth has strengthened;
  • Fiscal policy presents upside risks to growth and inflation; and
  • The upcoming leadership change among the Governors (and the Chair position in particular) argues for continuing to normalize the policy stance.

I think this framework has proven useful and remains valid, but the narrative has become a bit more complicated in recent months as the Committee has had to consider weaker inflation prints, a lower unemployment rate than projected, and less immediate traction on tax legislation. Putting aside fiscal stimulus for a moment, clearly there is an increasing tension between low inflation and a seemingly tight labor market, as Governor Brainard pointed out in a recent speech. In the near term, low inflation prints and an unemployment rate that has fallen further below the Committee’s NAIRU estimate have largely offsetting effects on the policy outlook – the Committee will raise rates next week by 25 basis point and will not make major changes to the projected path of rates. However if the inflation outlook remains muted, we can expect the Committee to hold off on raising rates further and to make significant changes to the Summary of Economic Projections (SEP) in September, such as a further mark-down to the NAIRU estimate, a weaker year-end 2018 inflation projection, and a shallower policy rate path through 2019. I will come back to the medium-term policy outlook further down; first I turn to the June meeting, where in addition to a rate increase I expect (i) the Committee to lower its end-2017 core PCE projection by a tenth (to 1.8 percent), (ii) some downward shift in the constellation of policy dots but no meaningful change to the medians, and (iii) additional news during the press conference on balance sheet policy. In addition, Chair Yellen is very likely to acknowledge less certainty about the inflation outlook and suggest that any further softness in the monthly prints could lead to a reassessment of NAIRU and the policy rate path.

The policy statement

Recall that the May statement served to communicate the Committee’s view that weaker-than-expected growth would prove transitory.  As such, the June statement may pick up on that theme and update it in light of recent data. For example the statement might indicate that “growth in economic activity has picked up” – language used in prior instances after passing through a soft spot.  On the labor market, the statement may acknowledge the slower pace of jobs growth – for example, and again drawing on past statements, “Although the unemployment rate has declined, job gains have diminished”. The Committee could signal that the decline in the pace of jobs growth stems from a tightening labor market, but I am not convinced members want to send such a hawkish signal, especially given weak inflation outturns. And on the inflation front, the Committee will have to rework the language. The May statement read:

“Inflation measured on a 12-month basis recently has been running close to the Committee’s 2 percent longer-run objective. Excluding energy and food, consumer prices declined in March and inflation continued to run somewhat below 2 percent.”

I found the above language on core PCE problematic even in May – to describe a then -1.6 per cent pace of inflation as “somewhat below” two per cent smacked of complacency, especially for a central bank that has struggled to convince financial market participants that it treats its inflation objective symmetrically. With the year-over-year rate having declined further since the May meeting, I suspect the Committee will revise this language, acknowledging the further decline and removing “somewhat”, i.e., “… consumer prices declined a bit further in April and inflation continued to run below 2 per cent”.

As for the forward-looking paragraphs, I expect few meaningful changes – the Committee still believes that the economy will expand at a moderate pace and that inflation will firm gradually to two per cent over the medium term, and that “gradual” increases in the policy rate will be appropriate. It is likely too soon to change the guidance on the balance sheet, but we should be very attuned to any changes here, which could signal that the Committee is considering beginning run-off in September. If the Committee did want to create additional optionality to start run-off in September (especially if it does not raise rates at that time), it could delete the second half of the sentence below, which references maintaining the full reinvestment policy until normalization is “well underway”. Many market participants (including myself) associate this language with a 1.5 per cent RIOER, and Governors Brainard and Powell strongly implied the same in their speeches ahead of the blackout period. Here is the current statement language on the balance sheet:

“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.”

Summary of Economic Projections

There have been few indications that Committee members are meaningfully reassessing their economic and policy outlook. Even a moderate dove like Brainard has stated that it is “premature” to reassess the outlook based on some recent weakening in the inflation data. As such, the broad picture that emerges from the SEP will be largely the same as in March – median projections for slightly above-trend growth, and an unemployment rate that remains below the NAIRU assessment and thus puts gradual upward pressure on inflation, necessitating a return to a neutral policy stance by 2019. But there will be some “marking to market” given recent data, and these changes will skew dovish:

  • 2017 GDP growth marked down a tenth, to 2.0 per cent.
  • 2017 unemployment rate down two tenths, to 4.3 per cent. The 2018 projection may decline a tenth as well.
  • Longer-run unemployment rate (which is similar to a NAIRU concept) marked down a tenth, to 4.6 per cent.
  • 2017 core PCE inflation down one tenth, to 1.8 per cent; 2018 and 2019 median projections to remain at 2 per cent.

As for the policy rate path, the median 2017 projection should remain at 1.4 per cent, signalling one more rate increase later this year as participants do not yet appear willing to throw in the towel on their overall outlook. For similar reasons, I expect the 2018 and 2019 medians, as well as the longer-run median, to remain unchanged. However, with the dovish Tarullo having retired, the 2018 median may move up a tenth to 2.20 per cent. This is likely a taste of things to come – if Quarles and Goodfriend will indeed soon be Governors, I would expect their rate projections to be above the current medians.

Press conference

I expect the Chair to provide additional detail on balance sheet plans in her prepared press briefing remarks. The key pieces of information to look for are:

  1. The size of the initial caps on allowable monthly Treasury and MBS runoff (I expect $10 and $5 billion caps, respectively);
  2. The increments by which the caps will be raised each quarter (again, $10 and $5 billion, respectively);
  3. How long the phase-out of the reinvestment policy will last (one year, in my view, and with steady-state caps on monthly Treasury and MBS of $40 and $20 billion, respectively); and
  4. The amount of excess reserves the Committee will target when the balance sheet is “right-sized”. This last issue is arguably the most important – the larger the steady-state size of desired reserves, the less balance sheet run-off will be required. I expect the Committee to have settled around a target $500 billion in excess reserves once the balance sheet is right-sized.

Outlook beyond June

I continue to expect a total of three 25-bp rate increases from the FOMC this year, but I have shifted my expectations for the timing of the third increase from September to December. This is because I think core PCE inflation will disappoint the Committee’s median projection for 2017, even after taking into account a downward revision at this week’s meeting to 1.8 per cent. After sluggish prints in recent months, the monthly inflation numbers would need to accelerate to an above-average pace relative to recent years in order to obtain the Committee’s projection, and there is little in the data to expect such an outcome. Yes, the labor market is showing signs of tightness for skilled workers, but this has not translated into aggregate wage gains over the past year. In addition, the weakness in the inflation numbers is spread out over a number of services categories, and goods prices remain in outright deflation. Inflation is also not rising meaningfully in other major economies, and this will likely constrain US import prices. And importantly, the risks of another debt ceiling crisis and government shutdown in the fall also will lead the Committee to turn more cautious in September.

One could argue that the Committee should not raise rates again even in December if core inflation will be no stronger this year than last. However, rightly or wrongly, the Committee still believes that it has to continue to raise rates gradually to return the policy stance to neutral by the time inflation firms to two per cent next year (as the Committee projects it will). In addition, by the fourth quarter there should finally be clearer progress on tax cuts, which the Committee views as an upside inflation risk. Absent a meaningful change in the growth and inflation outlook, I do not see much likelihood that the Committee will deviate this year from their strategy of continuing to nudge the policy rate towards their estimate of neutral.

Beyond this year, I do not consider the Committee’s median projection of a 3 per cent policy rate by the end of 2019 as credible. It is important to consider that the Committee views a 3 per cent nominal policy rate (or 1 per cent in real terms) as a neutral level – note that the median “longer run” interest rate projection sits at 3 per cent. So essentially, the Committee expects to have normalized interest rates by 2019. However, this outlook includes a critical assumption – that the real neutral policy rate, which currently sits at around zero per cent according to some estimates, will rise to one per cent by 2019. There is tremendous uncertainty in estimating the current level of the neutral rate, let alone its level in the future, but the low level of trend growth as well as a lack of supply of safe assets suggests that the real neutral rate is unlikely to rise very much by the end of 2019. I expect most FOMC members to come around to this view in the coming months, and expect the median rate path in the projections to flatten further by the end of the year.

Timing of Balance Sheet Normalization

Some sell-side economists and strategists have argued that if the Committee does indeed forgo a September rate increase, they will instead begin balance sheet normalization at that time. I have found this view difficult to understand. Most importantly, the Committee would need to explain why, if economic conditions do not warrant a tightening via interest rates, a tightening via the balance sheet would still be appropriate. In addition, the Committee cannot be certain that even a gradual initial pace of run-off will not lead to tighter financial conditions, and will be hesitant to take this step if they have already concluded that the inflation outlook remains subdued. As such, I would expect that a decision to delay a rate hike in December will necessitate pushing off balance sheet normalization slightly. One possible approach would be to announce at the December meeting that run-off will begin with portfolio maturities in January.

I recognize, however, that there is one very powerful argument for beginning run-off in September, and this argument concerns the Committee’s leadership transition.  The longer the Committee waits to start run-off, the higher the probability that newly-appointed Governors could object to the plan and request that the process be put on hold pending a new Committee Chair (assuming that President Trump does not re-nominate Janet Yellen). If this argument resonates with Committee members and run-off begins in September, they could start the process at an even more gradual pace than the $10 and $5 billion caps I mentioned above. They could then communicate that they decided to eschew a rate increase and instead tighten policy very modestly through the balance sheet given overall confidence in the outlook but a somewhat weaker-than-expected inflation profile.  Thus while a December decision to start run-off remains my base case, I recognize that a September start also remains a reasonable possibility in light of the upcoming leadership transition and the ability to start run-off at an extremely gradual pace to ensure an orderly start and credible communications.