Talking Points: June FOMC Cheatsheet
In terms of the immediate impact, the June FOMC meeting was closely in line with expectations – the Fed had already made clear that it was ready for another hike – so today’s meeting was more about the outlook for rates and the balance sheet. In that, it did not disappoint. Here are the key developments, a quick run-down of the main debate, and then reflections on the surprisingly interesting press conference.
FOMC statement & Addendum
· Rate hike of 1/4 of a percentage point, as expected, except for one dovish dissent (Neel Kashkari).
· Revisions to the current and expected economic conditions in light of recent data: job growth moderated, consumer spending picked up, and inflation softened. Risks remain "roughly balanced" but global economic and financial developments are no longer under close monitoring.
· Downward revisions to the projections for inflation (2017 only) and unemployment (across the board).
· More details about contraction of the balance sheet, earlier than expected. Roll-off will begin later this year, accelerating quarterly from $10 billion a month up to $50 billion a month. The final steady-state size of the balance sheet remains uncertain.
Why hike now?
Despite widespread expectations for a rate hike, Fed Twitter saw some debate on the wisdom of this move. Yes, unemployment is low, but inflation has softened and the yield curve is flattening, so what’s the rush?
As economist Tim Duy noted, this hike was all about the labor market. It’s also about risk management and the fact that monetary policy operates with a lag. Rate hikes take about 6-12 months or more to filter through to the rest of the economy, so with unemployment low and asset prices generally pretty strong, the Fed can’t afford to wait to see “the whites of the eyes” of inflation. Unemployment has already fallen below the point the Fed believes is sustainable, and job growth remains above the level needed to absorb new entrants and drive unemployment even lower. The Fed is not willing to risk inflation bouncing back. It wants to get back to neutral, which is why Yellen's comments in the press conference emphasized that “removing a bit of accommodation” is not the same as hitting the brakes.
More simply: while inflation has declined since the March Fed meeting, so has unemployment, and the Fed believes in the fundamentals of the labor market driving consumers, and in consumers driving the U.S. economy. For what it’s worth, the Taylor rule suggested the Fed should hike, and while the FOMC has deviated from that model quite a bit in recent years, everything about this meeting suggested the Fed is converging on a normalization of its policies.
· Balance sheet action likely in September. Chair Yellen said that the Fed may begin reducing its balance sheet “relatively soon” if the economy continues to track expectations, which suggests the emerging consensus about September is right. This was notable both because “relatively soon” has frequently been used as code for “at the next quarterly meeting.”
· In another sign that September is in the crosshairs, the Fed reached consensus on unwinding its balance sheet plan surprisingly quickly. In part, this reflects changes in the membership of the FOMC since the last major announcement in September 2014, but policy makers are also anxious to broadcast their plan well in advance of taking any action and again. They remain determined to avoid a repeat of the 2013 “taper tantrum.”
· Larger for longer. The Fed will retain the policy toolkit it expanded during and after the financial crisis, but return their focus to traditional tools. Yellen noted that the Fed is “not targeting financial conditions,” and while she noted forward guidance and balance sheet activity will remain on the table, the FOMC will see short-term interest rates as its primary tool. What went unsaid was that a willingness to actively manage the Fed’s balance sheet in the future will likely be a consideration in how large a securities portfolio to keep over the long term. The Fed has previously indicated it will maintain an expanded balance sheet, but guidance on the ultimate size has been sparse. Yellen said it will probably take years to get there.
· Yellen dismissed soft inflation data as due to one-off “idiosyncratic factors” and lingering baseline effects of the March report in particular. This suggests a relatively hawkish turn, with the Fed intent on normalizing its policy stance. The recent downturn in trimmed-mean PCE inflation suggests the weakness in price pressures may be more broad-based than the Chair indicated; notably, the decline in shelter costs is concerning, since that has been such a strong driver for so long. Be that as it may, Yellen's emphasis on the March report may give the FOMC grounds for dismissing soft inflation data for months to come -- long enough to keep tightening on pace.
· Inflation framework up for grabs: Yellen said the Fed will consider raising the inflation target. After 5 years of inflation below their target, the FOMC is clearly concerned. They don’t reconsider their economic theories lightly but in the meantime, Yellen stood behind the traditional theory of the Phillips Curve as still operative, if muted. We may be in store for a re-evaluation of how the Fed thinks about inflation, just as the Fed re-evaluated the unemployment rate a few years ago.