There’s something of a schism on the Federal Open Market Committee (FOMC) when it comes to inflation, but don’t let that fool you. So long as the economy keeps growing fast enough to hold unemployment at current levels, a solid majority of the Federal Reserve’s policymaking body is committed to gradual, but steady credit tightening.
Actually, Chair Janet Yellen and Co. don’t see themselves as tightening, merely “normalizing” monetary policy, making it less stimulative. As the FOMC said in mid-June after raising the Federal Funds rate for the second time this year, but just the fourth time since leaving the zero lower bound in December 2015, “monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2% inflation.”
The problem is the Fed’s preferred inflation gauge — the core price index for personal consumption expenditures (PCE) — had fallen three months in a row in May and was up just 1.4% above a year ago. That has prompted a number of officials to say the Fed should move slowly.
“I don’t see why we would not be served to allow more time to wait,” Chicago Federal Reserve Bank President Charles Evans said after voting for a hike in the funds rate target range to 1% to1.25% and for a plan to shrink the Fed’s $4.5 trillion balance sheet “this year.”
Dallas Fed chief Robert Kaplan, who also voted with the majority, said, “Before I’d be comfortable taking the next step in raising the Fed funds rate, I’m going to want to see more evidence that we are making more progress” toward hitting the 2% inflation target.
Nevertheless, the FOMC projected a third rate this year and six more during the next two years, and it readied a plan for shrinking the balance sheet through steadily escalating increases in the amount of maturing securities that will be allowed to run off.
Continued undershooting of inflation could influence the timing of rate hikes and implementation of the FOMC’s plan for capping reinvestments of maturing bonds. And it might affect the future funds rate path. But the predominant view is that inflation has been suppressed by one-off factors and is bound to rise to target.
Cleveland Fed President Loretta Mester said, “[I’d] be concerned if I saw some deterioration from those (inflation) reports on the demand side, like if the reason we’re getting the disinflation pressures was because demand is falling off, but I don’t see that in the data.” She added, “Those are more reflective of supply side considerations. So far, I haven’t seen enough to change my medium run outlook that inflation is on this gradual upward path.”
Yellen told Congress the Fed could “adjust” the funds rate path if the inflation undershoot proves “persistent,” but said it’s “premature” to come to that conclusion.
Low inflation is not viewed in isolation at the Fed. It’s not just that unemployment has fallen to 4.4%, although a vestigial belief in the Phillips Curve (an inverse relationship between the level of unemployment and the rate of inflation) still helps drive policy. Policymakers are also warily eyeing financial conditions. Instead of tightening in response to the Fed’s efforts, low bond yields, high stock prices and dollar depreciation reflect an easing of financial conditions.
Far from being an economic danger signal, some policymakers see low yields as a green light for further tightening. Richmond Fed chief economist Kartik Athreya didn’t go that far, but said the failure of yields to rise as much as expected in response to Fed rate hikes is “acting to confound their full effect.”
Mester doesn’t take low yields as “a negative signal” but adds, “I also don’t subscribe to the (notion) that, because long rates are low, we should do more on the short end. We should just stick with the gradual path that we’ve been viewing as appropriate.”
Easy financial conditions also tend to justify tightening if they seem to risk financial stability. Hawks like Kansas City Fed President Esther George have long warned that keeping rates too low too long generates excessive risk-taking and asset bubbles. Now Yellen and Vice Chairman Stanley Fischer are calling stock prices “rich.”
So the FOMC seems sure to follow through on its projection for hiking the Fed Funds rate a third time this year, and also plans for tapering of reinvestments this year. The question is when and in what order. Having moved more quickly than once expected to announce planned reinvestment limits, the FOMC could implement them at the September meeting, possibly starting in October. The third rate hike could then be made at the December meeting, depending on how inflation and other data unfold. But don’t rule out simultaneous rate and balance sheet action. It’s “a gradual plan, so there’s nothing in my mind that precludes us initiating that and doing something on the funds rate even at the same time,” Mester says. “If the data coming in are suggesting it’s time for another rate increase, I don’t see why that would preclude us on the balance sheet.”
Fed officials have gone to great lengths to avoid a repeat of 2013’s “taper tantrum” by announcing the balance sheet reduction well in advance and assuring everyone it will operate in the background.
“The key thing is that we’re trying to do this in a way that it’s not viewed as a change in policy stance,” says Mester.
The Fed hopes for a mild market reaction. If it is more adverse, the Fed seems more likely to delay rate hikes than to alter its balance sheet plan, but that will depend on whether the reaction is bad enough and long enough to alter the outlook.