David Page, Senior Economist at AXA Investment Managers (AXA IM), comments on January’s Federal Open Market Committee (FOMC) minutes.
- January’s FOMC minutes were interpreted hawkishly as confirming the likelihood of further “gradual adjustment” in Federal Funds Rate (FFR) across the course of the year.
- Minutes noted staff and FOMC participants increased their GDP outlook, expected further labour market tightening, but saw “a range of views” on the impact for wage growth.
- January saw discussion of recent inflation forecasts noting larger “prediction errors” in 2017. The Committee made no fundamental adjustment to its process, but “a few” members fundamentally disagree over the inflation outlook. Nevertheless, most were more confident of returning inflation to target over the medium-term.
- “Several” FOMC members raised financial stability concerns for the future.
- The Committee concluded that the shift in outlooks “increased the likelihood that a gradual upward trajectory of the FFR would be appropriate”
- We see this as further evidence that the Federal Reserve (Fed) will shift its outlook to four hikes this year in March (in line with our view).
January’s minutes showed that the underlying outlook for US activity had improved from its last meeting although in the absence of an update to the Summary Economic Projections (SEP) such guidance remained qualitative, rather than quantitative. Staff reported a “stronger” outlook than in December. “A number” of FOMC participants had “marked up their forecasts for economic growth in the near term”, while “several” considered that “upside risks may have increased”. Both groups identified looser financial conditions, a reassessment of the tax cut impact and faster foreign demand as the causes for these upgrades. That said, there was some caution that Q4 expansion may have been temporarily boosted by rebuild from hurricane damage.
This fed through to an improved outlook for the labour market. Staff described an outlook that saw unemployment “well below” estimates of the natural rate of unemployment. “Many participants” said they had reports of “tight” labour conditions, although a “few” still saw “some margin of slack”. However, there was less agreement over the outlook for wages with a “range of views described”. The staff reported “labour compensation remained modest”. “Some” participants described “reports of wage pressures from their business contacts”, but “generally noted few signs of broad-based pick-up in wage growth”. However, “a number” continued to expect that an improving labour market was “likely to translate into faster wage increases at some point”.
The outlook for inflation was preceded by a thorough discussion on recent performance of inflation forecasting. The minutes concluded that 2017 prediction errors were larger than in than 2001-07, but were not inconsistent with historic norms. More fundamentally most agreed that a resource utilisation approach to inflation forecasting remained useful (although “a couple” doubted this”). There was also discussion of possible non-linearities, suggesting inflation could rise more quickly if the economy operated “very high rates” of resource utilisation. This broad split of the Committee permeated through to the inflation outlook. The Fed staff inflation forecast was “was revised up slightly”, with “core PCE(1) to rise notably faster in 2018”. The FOMC views were more cautious, referring to greater confidence that inflation would return to target. Indeed, “Almost all” members thought that inflation would move up to target over the medium term. However, “some” considered an “appreciable risk that inflation would continue to fall short” stating “little solid evidence” that
economic growth or labour market tightness was “showing through to significant wage or inflation pressure”.
It was also noteworthy that in these minutes financial stability concerns appeared to increase. Staff noted “domestic financial conditions eased considerably further”, a view echoed by “many” participants. Additionally, “several” participants cautioned that “imbalances in financial markets may begin to emerge as the economy continued to operate above potential”.
All of this pointed to a more hawkish assessment for monetary policy. Participants agreed that a “gradual approach” remained appropriate. However, “members agreed that the strengthening in the near-term economic outlook increased the likelihood that a gradual upward trajectory of the FFR would be appropriate”. This explained the shift to “further” gradual increases referred to in statement to the meeting. “A couple” of participants also warned of inflation and financial stability risks originating from substantially overshooting full employment. We take this discussion of increased near-term growth forecasts, on balance rising confidence over inflation and simmering concerns over financial stability as further evidence that the FOMC is likely to adjust its rate projections in March’s meeting. We expect the median rate forecast to rise to four hikes for 2018 in March. We also expect three hikes in 2019. That said, the Fed’s ongoing insistence of “gradual adjustment” to us rules out the possibility of more than four hikes this year, for fear of sparking a more material tightening in financial conditions. Rather, we also expect the FOMC to adjust its estimate of the long-run FFR from its current 2.75-3.00%. However, we do not expect this shift in March, expecting this move later in 2018.
Financial markets reacted hawkishly to the minutes. 2-year yields edged higher to 2.28% after the minutes, although have retraced subsequently. 10-year yields broke above 2.90% to close yesterday at 2.95%, but have subsequently retraced back to 2.92%. The dollar also firmed rising 0.3% after yesterday’s minutes and currently still 0.2% higher than pre-release against a broad basket of currencies. Implied probabilities in swap markets suggest a 100% probability of a rate hike in March, a 75% chance of a subsequent rise in June and a 50% chance of a third hike in September, but currently suggest only a third chance of a further hike by year-end. To our minds, markets still under-price the chances of Fed rate hikes this year.
The minutes additionally noted:
- The neutral rate was “expected to rise slowly over time”, although some noted that it might “move up more than anticipated as the global economy strengthened”. This point was separately echoed by new Fed member Quarles overnight.
- The discussion about the inflation target continues to simmer. While this meeting reaffirmed the Fed’s commitment to a 2% PCE inflation target as the most consistent definition of its “stable price” mandate, a few suggested consideration of a target range for inflation, or price-level targets.
- The flattening of the yield curve. One member noted markets did not see this as signalling an increased chance of recession”, but “a few” advocated monitoring developments.