The September FOMC meeting provided Chair Yellen one of the ultimate achievements in central banking: boredom in the midst of momentousness. In this, it served as a fitting capstone for her (first or only?) tenure as Fed Chair, which has been consumed with tiptoeing away from extraordinary policy measures as much as Ben Bernanke's tenure was consumed with escalating and extending them. There were some interesting revelations about the Committee's evolving views on the outlook for the economy and future rate hikes -- as expected, the December meeting was very much in focus -- but otherwise the materials published and the press conference were successfully dull. Bad news for financial journalists, but good news for the world economy.
What They Did
- Announced the start date for balance sheet reduction. Finally!
- No change in rates.
- More significantly: no change in the median dot for December 2017 (although three hawkish dots descended to the median). Median dots still call for 3 hikes in 2018, but only 2 in 2019.
- Updated the economic forecasts: faster GDP growth in 2017 & 2019, lower unemployment in 2018-19, lower core inflation in 2017-18, lower policy rates in 2019 and the long run. The First forecasts for 2020.
- Slight changes to the statement, aside from noting that the effects of the hurricanes should prove transitory for the national economy.
How & Why They Did It
- The big announcement about the balance sheet was years in the making. This was the end of the beginning of normalization, and it's worth reviewing the journey. The Fed drafted a first set of "exit principles" in June 2011, then a revised set in September 2014, began tapering its asset purchases starting in December 2013, and raised rates off the zero lower bound in December 2015. Along the way, it replaced forward guidance with data dependence, adopted a patient and gradual approach to rate hikes, and rebuilt its toolkit for actually effecting rate hikes.
- It will take years for the Fed's balance sheet to stop shrinking and where the process stops is a question the FOMC is still debating, as they ponder their longer-term post-crisis policy toolkit.
- In the press conference, Yellen made clear that future balance sheet expansion would be use only as a last resort and as a means to boost growth, not inflation (not unlike fiscal policy).
- Clearly the majority of the Committee wants to keep a December hike in play. No doubt the rebound in the August CPI report was reassuring, but the asymmetry of risks was probably just as important. Although the FOMC had no trouble quickly talking the market into a rate hike ahead of the March meeting this year, they have shown a consistent bias throughout the recovery to hold an optimistic line and relinquish projected hikes only when necessary.
- In the press conference, Yellen emphasized the strength of the U.S. economy and the risk of higher inflation, rather than financial conditions, as grounds for further rate hikes. The Fed may or may not be concerned about asset price inflation, but clearly the Chair has no interest in calling a bubble or undermining market confidence.
The modestly hawkish stance puzzled some commentators who focused on the lower forecasts for inflation and long-term rates. I see this as an extension of Vice Chair Fischer's logic in talking about "ultra-expansionary" vs. "extremely expansionary" policy back in March 2015. The Fed is aware that inflation is far from a sure bet, but they can't just abandon their traditional models. The prudent step at this point is to get policy to approximately neutral, so that the Fed is ready to respond to any signs of consumer price inflation taking off. In wonkier words, the Committee just told us they think the short-term neutral rate is no longer negative.
No mystery here: it's all about the December meeting, when another rate hike is in the cross hairs. With overall growth and the labor market looking good right now, it's all about the inflation data. It would probably take another leg down in core inflation to push out the next rate hike. This is especially true since the growth and employment data may be muddied by the effects of the hurricane season. Gas prices won't help either, but the Fed will look past them to focus on core inflation.
Financial conditions will also be worth keeping track of. Part of why the Fed is now shrinking its balance sheet is because it has not seen its prior rate hikes filter out into broader financial conditions. As the Fed effectively releases more bonds out into the open market (mechanically its just a reduction in the amount of reinvestments), that should relieve downward pressure on interest rates and give their rate hikes more bite. If they don't, talk of a second "conundrum period" may pick up. As it is, 30-year and 2-year Treasury yields are near their narrowest gap since the end of 2007. History doesn't repeat, but look out for the rhymes.