FOMC prepares ground for tightening

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The FOMC minutes were out last night. Here are the money paragraphs:

With respect to monetary policy over the medium run, participants generally agreed that labor market conditions and inflation had moved closer to the Committee’s longer-run objectives in recent months, and most anticipated that progress toward those goals would continue. Moreover, many participants noted that if convergence toward the Committee’s objectives occurred more quickly than expected, it might become appropriate to begin removing monetary policy accommodation sooner than they currently anticipated. Indeed, some participants viewed the actual and expected progress toward the Committee’s goals as sufficient to call for a relatively prompt move toward reducing policy accommodation to avoid overshooting the Committee’s unemployment and inflation objectives over the medium term. These participants were increasingly uncomfortable with the Committee’s forward guidance. In their view, the guidance suggested a later initial increase in the target federal funds rate as well as lower future levels of the funds rate than they judged likely to be appropriate. They suggested that the guidance should more clearly communicate how policy-setting would respond to the evolution of economic data. However, most participants indicated that any change in their expectations for the appropriate timing of the first increase in the federal funds rate would depend on further information on the trajectories of economic activity, the labor market, and inflation. In particular, although participants generally saw the drop in real GDP in the first quarter as transitory, some noted that it increased uncertainty about the outlook, and they were looking to additional data on production, spending, and labor market developments to shed light on the underlying pace of economic growth. Moreover, despite recent inflation developments, several participants continued to believe that inflation was likely to move back to the Committee’s objective very slowly, thereby warranting a continuation of highly accommodative policy as long as projected inflation remained below 2 percent and longer-term inflation expectations were well anchored.

…Members discussed their assessments of progress–both realized and expected–toward the Committee’s objectives of maximum employment and 2 percent inflation and considered enhancements to the statement language that would more clearly communicate the Committee’s view on such progress. Regarding the labor market, many members concluded that a range of indicators of labor market conditions–including the unemployment rate as well as a number of other measures of labor utilization–had improved more in recent months than they anticipated earlier. They judged it appropriate to replace the description of recent labor market conditions that mentioned solely the unemployment rate with a description of their assessment of the remaining underutilization of labor resources based on their evaluation of a range of labor market indicators. In their discussion, some members expressed reservations about describing the extent of underutilization in labor resources more broadly. In particular, they worried that the degree of labor market slack was difficult to characterize succinctly and that the statement language might prove difficult to adjust as labor market conditions continued to improve. Moreover, they were concerned that, despite the improvement in labor market conditions, the new language might be misinterpreted as indicating increased concern about underutilization of labor resources. At the conclusion of the discussion, the Committee agreed to state that labor market conditions had improved, with the unemployment rate declining further, while also stating that a range of labor market indicators suggested that there remained significant underutilization of labor resources. Many members noted, however, that the characterization of labor market underutilization might have to change before long, particularly if progress in the labor market continued to be faster than anticipated. Regarding inflation, members agreed to update the language in the statement to acknowledge that inflation had recently moved somewhat closer to the Committee’s longer-run objective and to convey their judgment that the likelihood of inflation running persistently below 2 percent had diminished somewhat.

With falling commodity prices and a firm US dollar, inflation is not going to take off. Nor is the Fed going to get ahead of markets. Mid next year remains the base case for the first hike.

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Equities were stable as such. Short end bonds sold hard but the long end barely budged. The Aussie took a 30 pip dump, giving back the gains from yesterday’s RBA folly. The US dollar jumped nearly a half cent and looks like its running. Gold sold a little and oil rallied.

Goldman is sounding hawkish:

BOTTOM LINE: The July FOMC minutes generally had a slightly hawkish tone, emphasizing that labor market slack had improved faster than expected and that the labor market was now closer to what might be considered normal in the longer run. Separately, there was an extended discussion of exit strategy, at which the Board staff laid out a framework that was well received by meeting participants.

MAIN POINTS:

1. Regarding the assessment of the labor market, many Committee members agreed that a number of indicators of labor market conditions had “improved more in recent months than they had anticipated earlier.” Many members further noted that the FOMC statement’s “characterization of [significant] labor market underutilization might have to change before long, particularly if progress in the labor market continued to be faster than anticipated.” The broader set of meeting participants agreed that the rate of improvement in the labor market had been faster than anticipated, and that “conditions had moved noticeably closer to those viewed as normal in the longer run.” Overall, these remarks suggest that the change in the labor market language found in the July FOMC statement—shifting focus to broader labor market indicators rather than the unemployment rate specifically—was not intended to be a dovish change, as some commentators thought at the time. To the contrary, the discussion of labor market developments in the minutes had a hawkish tilt.

2. In a similar vein, the staff revised down its estimate of potential GDP growth, in light of the continued outperformance of labor market indicators despite disappointing GDP growth. This suggests that the staff reduced their estimate for the size of the output gap, a slightly hawkish signal.

3. The discussion on inflation was less substantive than on the labor market, with “most” participants now judging that downside risks had diminished. Committee members agreed that it was appropriate to recognize that inflation had moved closer to the Committee’s objective in the statement, suggesting that they viewed the recent uptick in the inflation trend as having some staying power.

4. The recovery in housing was described as “slow” by most participants, facing headwinds such as high levels of student loan debt and tight access to credit. Some felt that “factors restraining residential construction might persist, damping the housing recovery for some time.”

5. On financial imbalances, participants noted some evidence of stretched valuations in specific markets, but on the whole felt that the phenomenon was not widespread and that “vulnerabilities in the financial system were at low to moderate levels.” This is consistent with prior communications from Fed officials.

6. There was an extended discussion of exit strategy. The staff presented a “possible approach,” for which participants “expressed general support.” Key aspects of the approach apparently included: (1) continuing to target a range of 25 basis points for the federal funds rate (i.e., the first hike could be a move to a target range of 25 – 50 basis points); (2) the top of the range would be set equal to the interest rate paid on excess reserves (IOER) and the bottom of the range set equal to the rate on the fixed-rate O/N RRP facility; (3) the size of the O/N RRP facility should “be only as large as needed to effective monetary policy implementation and should be phased out when it is no longer needed for that purpose”; and (4) most favored reducing or ending portfolio reinvestment after the first increase in the target range for the fed funds rate. Some felt that the O/N RRP rate should be set below the bottom of the target range, which would further discourage use of the facility, but many participants thought such a strategy would provide insufficient control over the level of rates.

Forgive the above image. It was all I could think of. ‘Tightening” is all relative!

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.