Across the Curve

There were no Earth-shattering surprises in the March FOMC minutes, but, as usual, several useful nuances were revealed.

Economic outlook

Participants acknowledged that Q1 GDP was shaping up to be soft, mainly due to the soft January consumer spending figures.  However, the FOMC was broadly confident that this was a transitory bump in the road, as low Q1 growth had proven to be in several prior years.  Participants generally viewed the outlook as having changed little since the last meeting six weeks before.  Business spending was showing more signs of life, but most contacts remained in a wait-and-see mode until there was more clarity on tax policy changes.  The labor market was still viewed as strong.  In fact, “nearly all participants judged that the U.S. economy was operating at or near maximum employment.”  There was more anecdotal evidence cited that labor markets are quite tight, including reports of firms’ difficulty in finding qualified job candidates to fill openings.  In any case, the main debate with regard to the labor market outlook was whether there would be a modest overshoot relative to the longer-run equilibrium unemployment rate, the view of most participants, or a “more substantial undershoot,” the view of some others.  The former group apparently believes that the unemployment rate will magically stabilize at 4.5% by the end of this year and stay there indefinitely simply because the Committee wants it to, while the hawkish minority has economic theory and logic on its side.

On inflation, progress has been made but we are not quite “there” yet.  “Nearly all members judged that the Committee had not yet achieved its objective for headline inflation on a sustained basis,” while core inflation continues to run “somewhat below 2 percent.”  All true.  Of course, the data for February released last week gets us ever closer to the Fed’s dual mandate objective, as headline inflation exceeded 2% on a year-over-year basis for the first time in 5 years, while core inflation continues to inch toward that mark.  The debate in March seemed to center around what it takes to meet the Fed’s inflation target.  “A number of participants” see core inflation of 1¾% as “well below 2%” (even as the minutes explicitly cited the 1.9% reading for the Dallas Fed trimmed mean PCE) and likely to remain there for “some time.”  Several others see headline inflation of 2% and core inflation of 1¾% as essentially meeting the inflation goal or, at worst, suggesting that the goal will be met later this year.  These participants, the hawks, see the possibility that faster rate hikes than the median SEP projection would be warranted (that interpretation of the inflation debate is very much in line with my view).

There was as much or more discussion of risks in this set of minutes as I can ever remember.  As we know from the statement, the risks were generally viewed as “roughly balanced.”  However, after years on end when the risks were consistently seen by the Fed as skewed to the downside, the outlook has witnessed a sea change in recent months.  The FOMC is apparently not going to admit that the risks are now skewed to the upside, but when you see the list of risks offered by the Committee, it sure feels that way.  First and foremost, the prospect of fiscal policy changes was said to introduce upside risk.  At the same time, downside risks associated with the global economy had diminished.  At one point, a list of risks that could lead the FOMC to change its assessment for the appropriate path of the funds rate was offered.  The skew of this paragraph certainly makes it feel like the risks are tilted to the upside.  There was “the possibility of stronger spending by businesses and households as a result of improved sentiment, appreciably more expansionary fiscal policy, or a more rapid buildup of inflationary pressures than anticipated.  In addition, a number of participants remarked that recent and prospective changes in financial conditions posed upside risks to their economic projections.”  Meanwhile, on the downside there was only the half-hearted offerings of the possibility of a significant correction in financial markets and a vague mention of “potential developments abroad.”

March Rate Hike

The most striking aspect of the discussion of the March rate hike in the minutes is the nonchalance accorded the move.  Recall that markets were pretty adamant that the Fed would not go until Fed officials had to verbally whack them over the head with a 2×4 in the last week of February.  And yet, the minutes make it seem as if this was obvious all along.  The Committee specifically affirms that its economic forecast had not changed since the last meeting (or the December one for that matter) and that a rate hike in March was entirely consistent with the Fed’s strategy of “gradual” normalization.  Indeed, the one change in the statement that was evidently heavily discussed was introducing a specific allusion to the fact that the inflation target is symmetric as an effort to boost/support inflation expectations, i.e. a dovish innovation at the margin.  So, the picture that the Fed apparently wants to convey is that the March rate hike was pretty much in the cards all along, i.e. market participants just misunderstood the FOMC’s intent up until the end of February.

Balance Sheet

It appears that the FOMC finally began to consider seriously how and when to begin working down the balance sheet in March.  No final decisions were reached, but a number of things were discussed and debated.  The Committee began by reaffirming the 2014 framework, namely that reductions in the Fed’s holdings should be “gradual and predictable,” and “accomplished primarily by phasing out reinvestments of principal received from those holdings.”  In other words, no outright sales (at least not early on).

The Committee also emphasized that the funds rate would be the primary means for adjusting monetary policy.  This is probably the most important element of reinvestment strategy.  Contrary to the markets’ dogged insistence otherwise and somewhat at odds with what a few Fed officials have suggested, there is not likely to be much of a trade-off between rate moves and balance sheet reduction.  Instead, the Fed would like balance sheet reduction, once it begins, to be largely background noise.  Barring a repeat of the taper tantrum episode from 2013 (which I do not expect), I doubt that the timing and pace of balance sheet reduction will have anything more than a marginal impact on the path of the funds rate target.

Participants felt that the timing of a change in reinvestment policy should be tied to economic conditions.  In particular, “several” felt that it should be tied to reaching a certain level or range on the funds rate.  The Committee was not specific in pegging a number but noted that if the economy evolves as expected, “most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year.”  So, we can do the math and figure that the FOMC wants to get 1 or maybe 2 more rate hikes under its belt (the median expectation was/is 3 for the year) and then wants to crank off the balance sheet reduction effort.  This is the clearest signal yet that this will be a second half of 2017 story, in line with my long-held view.

There was a debate but no clear consensus on whether the Fed should taper reinvestments down gradually or stop them all at once.  The former approach would reduce the risks of market volatility, while the latter would be easier to communicate and would allow for a quicker reduction.  This is interesting, because I would say that the near-universal view among market participants has been that it would be a slow taper.  This suggests that there is a risk of more aggressive balance sheet shrinkage than has been previously assumed.

Finally, “participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS.”  There have been all sorts of cutesy scenarios laid out by Wall Street economists and analysts, but this misses the boat.  The fact is that the Fed wants to be as quiet and simple about this as it possibly can.  So, the Fed is unlikely to do anything other than the simplest possible scenario – either end reinvestments altogether for both Treasuries and MBS at the same time or phase them out in proportion (start by allowing either a certain dollar amount or a certain percentage of maturing securities from each type of security to roll off and working up to a full halt).  Anything more complex than that makes it seem that the Fed is trying to use balance sheet reduction to fine-tune policy, and that is quite clearly the opposite of their intentions.  Moreover, my guess is that when we get the initial announcement, if the FOMC chooses the taper option, then it may offer a contingent path all the way to the end of reinvestment.  What the Fed clearly wants to avoid is having to make discretionary decisions on the reinvestment taper path at each meeting, which will only serve to focus markets’ attention onto something that the Fed clearly wants to be nothing more than background noise.