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Latest FOMC Minutes Show Fed Shifting Into Neutral

Published 2018-07-09, 02:30 a/m
Updated 2023-07-09, 06:31 a/m

by Darrell Delamaide

After a decade of accommodative monetary policy designed to boost the US economy out of recession and support a flagging recovery, Federal Reserve policymakers are ready to move quickly to a neutral stance, one that neither spurs growth nor restricts it, according to details of the central bank’s latest meeting.

The Federal Open Market Committee voted to raise rates by 25 basis points last month and signaled two more rate hikes this year. The minutes, released this past Thursday, reflect confidence that robust economic growth will continue, but also indicate a wariness of a coming need to put the brakes on an economy that should not run too hot, too long.

The Fed's favored inflation gauge, the personal consumption expenditures (PCE) index, hit the Fed’s 2% target in April. Given how long inflation has run below the target, “a few participants” noted inflation measures derived from financial markets indicate below-target inflation to continue long term. But others were worried an above-potential economy for a “prolonged period” could create inflation enough for a “significant economic downturn.”

After the Fed meeting, the PCE Index for May came in at 2.25% year on year and 1.96% for the core index, which excludes food and energy prices, that the Fed watches. Participants at the meeting anticipated that somewhere down the road, the core index might actually exceed the overall index because of a projected decline in consumer energy prices in 2019 and 2020.

Eyes on the yield curve

Markets also have been paying a lot of attention to the flattening yield curve: the narrowing of the gap in yields between 2-year and 10-year Treasuries. An inversion, when the short-term yield exceeds the long-term yields, historically has heralded a recession.

This was not lost on FOMC members. They debated whether factors such as the gradual increases in the Federal funds rate or the effect of the Fed’s asset purchases in depressing long-term yields might make this a less accurate barometer and will continue to monitor this indicator closely.

June nonfarm payrolls won’t change thinking

Unemployment at 3.8% percent in May was below what Fed policy makers consider normal. “Several” participants felt that there is less tightness than this might indicate because a strong labor market may draw more people into the workforce.

In any case, regional bank presidents reported that many companies were having trouble finding qualified workers. They were increasing salaries and benefits, providing training for less-qualified workers, or investing in automation. The Fed policymakers still believe, by and large, in the Philips curve, where wage inflation picks up if the jobless rate remains this low.

June nonfarm payrolls—reported on Friday, one day after the FOMC Minutes release—grew by 213,000, the Labor Department reported. Despite the healthy increase, which was a tad higher than forecasts of 200,000 new jobs, the headline unemployment rate rose to 4% from 3.8%. Summer job seekers flooding the market after the school year ended may have accounted for the rise, although the numbers are seasonally adjusted. But there was nothing in the report that would alter the Fed’s outlook.

Fed will overshoot, could hit neutral in 2019

One cloud on the FOMC’s horizon was the tension surrounding world trade as threats of tariffs and retaliation grew. “Most participants” said these tensions had intensified and they were concerned about business sentiment and investment.

In the meantime, the Fed is ready to overshoot everything. It's willing to let inflation go above its 2% target for a while to make up for lost time and to boost inflation expectations. And it is willing to let unemployment sink below sustainable levels for some time. By the same token, it will not hesitate to raise the Fed funds rate above its long-term normal if necessary to cool down the economy.

Participants “generally” felt that with the economy already very strong and with inflation expected to run at a sustained 2% rate over the medium term, it would probably be appropriate to gradually raise the target range to somewhere at or above 2019-20 estimates.

At its current clip of four quarter-point hikes a year, the Fed could reach its neutral level of 2.75% to 3.0% (and surpass it) next year. As neutral approaches, “a number” of participants noted it might be time to modify the language of the consensus statement to remove the long-standard phrase “the stance of monetary policy remains accommodative.”

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