Beckner: FOMC Minutes to Show Split on Rates, Consensus on Balance Sheet

10 August, 2017

By Steven K. Beckner

  Whatever its short-term interest rate course turns out to be the Federal Reserve gave strong indications in its July 26 Federal Open Market Committee statement it is close to lifting its steadying hand from the long end of the yield curve. The FOMC's vow to start normalizing the bloated balance sheet "relatively soon" was justifiably interpreted as implying a September launch for its previously announced plan of graduated caps on reinvestment. The minutes will likely reinforce that impression.   Expect the minutes to show continued concern and dissension about below target inflation, but also a remarkable degree of agreement on some aspects of monetary policy. With the June PCE price index up 1.4% from a year ago (1.5% core), the minutes are apt to reveal divisions about the appropriate path of the federal funds rate. But they're also sure to show strong consensus on balance sheet reduction. Strong economic and financial conditions help offset low inflation in policymakers’ minds. When the FOMC met they had a solid June employment report in hand. The July numbers are more encouraging in some ways. Not only did non-farm payrolls rise a more-than-expected 209,000, June gains were revised higher. Despite increased labor force participation, the unemployment rate fell to a 16-year low at 4.3%. And there were tentative signs of faster wage growth. Average hourly earnings rose 0.3%, the best in five months. Wages are still up just 2.5% from a year ago, but Fed research shows better gains for those who change jobs. Even the average increase should fuel enough income growth to keep the economy growing at least 2% -- adequate relative to the FOMC's estimate of GDP potential to justify continued tightening. Fed officials recognize it will be tough to get faster wage gains without increased productivity growth and/or higher inflation. Boston Federal Reserve Bank President Eric Rosengren says, "I think we're getting to the point in many places where they're saying, 'It's going to cost me too much money not to hire the extra labor. It's worth paying those higher wages.’" There is enough residual belief in the Phillips Curve that many officials expect tight labor markets to induce wage-price pressures -- hence their confidence inflation will rise to 2% “over the medium-term.” Meanwhile, equities keep setting records, while former Fed Chairman Alan Greenspan fears a bond market "bubble." Nevertheless, concerns about inflation are leading to a kind of policy bifurcation that will probably be on display in the minutes. The contrast between disagreement about the funds rate path and agreement on the balance sheet came through starkly in a pair of interviews I conducted. On one hand, as I reported last month, Cleveland Fed President Loretta Mester has "not seen enough to change my medium run outlook that inflation is on this gradual upward path." Hence, she did "not see the data coming in as meaning we need ... a major reassessment of the (funds rate) outlook. I'm comfortable with the gradual path we've been laying out for quite some time, and I'm comfortable also with the things we've talked about in terms of the balance sheet." Indeed, Mester told me "there's nothing in my mind that precludes us initiating that (balance sheet reduction) and doing something on the funds rate even at the same time." On the other hand, St. Louis Fed director of research Christopher Waller said more recently there is no case for raising short-term rates given low inflation. Equally he sees no justification for depressing long rates down while raising short ones. "We've got an inflation target of 2% for five years, and we haven't hit 2% yet, except for very brief moments...," said Waller, President Jim Bullard's top advisor. "So at some point how much of this is science versus faith in your forecast that it goes back to 2%?" Waller says low inflation is "more than transitory" and argues full employment doesn't matter "if it doesn't have any (inflation) costs." The FOMC has projected a third rate hike for 2017 and six more for 2018-19 -- taking the funds rate to the 3% "longer run" estimate. But believing the real equilibrium rate is -1%, Waller and Bullard "don't see any reason to be hiking rates at all over the next two years, because we look at the economy; inflation, if anything is a little low, unemployment is close to full employment. GDP is right on target, and we don't see lot of financial instability." "So why are we trying to raise rates 200 basis points?" Waller asked. "Give me a reason." Yet, while fighting short-term rates hikes, Bullard and Waller have argued since December the Fed should curtail reinvestments and allow long rates to rise. Contradiction? No, says Waller: "the contradiction is: why is the Fed keeping the balance sheet (unchanged) to put pressure on long term rates while they're pushing up short term rates?" "If you're trying to push up rates, you should be pushing up all rates, including the long end of the yield curve, and by having this balance sheet policy we're keeping those rates suppressed," said Waller. "So why are we raising the short end and trying to keep the long end suppressed?" "If you're going to raise rates, try to force up the entire yield curve, not flatten it," Waller elaborated. "The longer we wait and push up short rates the more distorting of the yield curve we're doing. So get going!" Admittedly, those bipolar positions don't fully reflect mainstream FOMC opinion, but they do delineate the issues policymakers face. Although not all officials think low inflation justifies no rate hikes, neither do they necessarily agree that the FOMC should proceed with rate hikes despite low inflation. The center position likely to come through in the minutes is that low inflation is worrisome enough to warrant deferring rate hikes, but does not justify delaying balance sheet reduction. The minutes seem likely to confirm expectations of September balance sheet reduction and December rate action. Though three weeks old, the minutes will perform an important communication function --- continuing a coordinated effort to prepare markets for beginning a phase-out of the reinvestments that have prevented balance sheet shrinkage. The Fed has taken extraordinary care to ready markets -- the idea being, as Mester said, to avoid leaving the impression that balance sheet reduction implies "a change in policy stance." It's been a long road, but the Fed has posted signs all along the way, and lately they’ve been flashing green. After halting "quantitative easing" in October 2014, the FOMC declared, "The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction." The FOMC said "this policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions" -- a statement repeated until June. Starting late last year, officials dropped heavy hints the Fed would curtail reinvestments before long. After holding intensive preparatory discussions at the May 2-3 meeting, the FOMC announced on June 14 it "expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated." Moreover, it announced a detailed plan earlier than many had expected. Under that plan, the Fed would slowly but steadily reduce its bond portfolio by reinvesting principal payments from maturing securities only to the extent they exceed gradually rising limits. For Treasury securities, the caps will start at $6 billion per month and increase by $6 billion every three months until they reach $30 billion per month over the course of a year. For agency debt and mortgage-backed securities, the cap begins at $4 billion per month and increases by $4 billion every three months until it reaches $20 billion per month. The FOMC anticipated "the caps will remain in place once they reach their respective maximums so that the Federal Reserve's securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively." As Fed assets shrink, reserve liabilities will decline "to a level appreciably below that seen in recent years but larger than before the financial crisis." Then last month, the FOMC told us it will implement that plan "relatively soon." The minutes are likely to confirm this means Sept. 20, when the FOMC will presumably name a start date, perhaps in early October. The Fed hopes that, by so carefully preparing the markets and easing into it so gradually, actual tapering will have minimal impact. In 2013, when then-Chairman Ben Bernanke's hints at a phase-out of asset purchases spiked yields, "we didn’t prepare the markets at all for tapering, and hence you got the tantrum," Waller recalled. This time, "we have told everybody for seven months this is coming; get ready, and here's the actual plan for it," Waller continued. "So I will be personally stunned" if there is a bad reaction...,"We're rolling off small amounts. I mean this is like nothing." The minutes may well disclose a discussion of the probable impact of balance sheet reduction. But they will likely reflect minimal trepidation. Officials sound supremely confident, even as they continue trying to ward off turmoil with reassurances. San Francisco Fed President John Williams recently stressed "it should take about four years to get the balance sheet down to a reasonable size." And he added, "Importantly, this process of shrinking our balance sheet will take place in the background…" He and others have promised the process will be “boring.” At the upper limits, the Fed will shrink its Treasury and MBS holdings at a $50 billion per month or $600 billion per year pace. But officials confide the caps are not really binding, particularly for Treasuries, since there will be months when large amounts mature and be capped and other lighter months when reinvestments won't be capped. So instead of $600 billion per year, the reduction may be much less. In any case, officials do not expect much impact on yields. Indeed, some say if long rates don't respond as much as expected, the FOMC may have to be more aggressive. "So if this causes turmoil I would be personally at a loss for what's causing it," Waller said. "It's very tiny amounts, and we told the plan -- here it is, you can do the math on what the roll-off is going to look like. And so you've got as much of a road map as we can possibly give you on what the balance sheet roll off is going to look like. So if that catches you by surprise you weren't paying attention the last eight months." Waller observed that "so far we haven’t seen a whole lot of market reaction," even though "the market seems to be expecting it in September. I'm not seeing any tantrums, I'm not seeing any problems popping up in the market to suggest we're blowing how we're doing this." It remains to be seen how much impact reinvestment tapering will have on long rates. Although the FOMC has often said reinvestments make financial conditions more accommodative, it's debatable how much downward impulse they have given to long-term rates. Prospective estimates vary, but Kansas City Fed research estimates a $675 billion balance sheet reduction over two years will equal a 25 basis point funds rate hike. Other, more important factors have depressed long-term rates. Vice Chairman Stanley Fischer recently observed that "longer-term interest rates in the United States have remained low even as the (FOMC) has increased the short-term federal funds rate by 100 basis points and as the unemployment rate has declined below the median of FOMC participants' assessments of its longer-run normal level." Fischer said lower inflation and inflation expectations explain only some of the decline in nominal long-term rates. More important is a worldwide decline in the real equilibrium, "natural" interest rate due to a global economic slowdown, which he attributed to slower labor force and productivity growth, the latter because of weaker investment. Federal Reserve Board research finds the natural rate (r*) has declined 150 basis points in the United States since the financial crisis to about 50 basis points. Others, such as Waller, put r* at zero or less. Besides those forces, Waller opined that "maybe the Treasury isn't issuing enough debt given the world demand for it. So that drives up the price and lowers the yield on it. "U.S. government debt is one of the few safe assets in the world, and the world is clamoring for safe assets for a variety of reasons," he elaborated, "and so the question is: if you are the issuer of safe assets, why are you not providing the world with safe assets?" Beyond the need to normalize reserve balances, Waller sees this shortage of safe assets as another reason for the Fed to slash its bond holdings: "If the world is demanding safe assets, why are we sucking them out of market? Put them back into the market for people to hold onto. If the world wants safe assets and the Treasury won't provide them, we're sitting on $2.5 trillion. Let's get rid of them. Let people have them who want to pay for them." In any case, if there is a rebound in bond yields, analysts should look at more than just Fed tapering.