While the Fed did not make any explicit moves at its July 26 meeting, the minutes of which were released today, it strongly hinted that it would begin slowing the pace of bond reinvestments at the next meeting. So these minutes could shed some light on that debate. But perhaps more importantly, I'm looking for some clarity around how the Fed is thinking about employment and inflation.
A debate is raging among economists about whether the Fed should be waiting for more inflation before hiking again or needs to pre-emptively hike given the very low level of unemployment. Since the Fed collectively seems to side with the latter argument, what exactly has it convinced? The state of the debate in these minutes gives us some clues about this and what might change the Fed's mind. This is crucial to understanding how 2018 evolves.
The End of QE as We Know It?
The minutes read like the Fed reducing the pace of QE reinvestments in September was a foregone conclusion. I've been asked many times about how I think this will impact rates and/or the mortgage-backed securities market. I think the effect will be very minimal, as even at its peak, the Fed's buys will be just 0.34% of average daily volume between the two. The plan to reduce reinvestments has also been very well telegraphed, presumably allowing the market to slowly price in the change in effective supply.
What's more interesting is that the Fed seems to want to wind down its balance sheet no matter what happens. This suggests it too thinks the pace of the wind-down is so slow that it won't have much impact in any given month. But it also means the Fed doesn't think there is any cumulative effect of having a large balance sheet.
I think that's notable for the future. It means the Fed doesn't think QE has any cumulative effect on rates, just an effect in the moment they are traded. That has a lot of implications about how it will execute such a policy tool in the future.
Why Is Inflation Slowing?
The Fed seemed a good bit more worried about the recent inflation slowdown than has been evident in recent minutes. In June, it dismissed lower inflation as due to one-offs (mobile phone pricing, mainly), which always seemed suspect. Now that the soft inflation prints have continued, the Fed is more concerned. "Many [worried about a] likelihood that inflation might remain below 2 percent for longer than they currently expected." And, "Several indicated that the risks to the inflation outlook could be tilted to the downside."
This language is much stronger and seems to have been shared by a larger number of members than at prior meetings.
Does this put a December hike at risk? Perhaps somewhat. I always said the Fed's default position was to hike in December, but only if we saw a major downturn in inflation. I think if core PCE rebounds to just 1.5% or so, I still think they are hiking. This only suggests that the Fed isn't hiking no matter what.
What About Employment?
New York Fed President William Dudley has recently said in various speeches that he's worried that unemployment could "crash" lower. His concern is that this could cause unwanted inflation and, unless it does some hiking now, the Fed would be behind at that point. This viewpoint reflects the so-called Phillips Curve effect, which is a purported relationship between inflation and unemployment. I've written about this a few times recently, so I won't go into much detail here. Suffice to say that the Phillips Curve has been controversial for many years, as it has been difficult to find in actual data. Today, with unemployment continuing to fall but inflation not accelerating, the Phillips Curve is particularly under fire.
There seemed to be a hot debate during this meeting on the Phillips Curve. Ultimately, most seemed to still believe lower unemployment would ultimately create inflation pressure. But we should note that the debate had plenty on both sides.
This matters quite a bit. If most members believe the Phillips Curve effect is real, then they will want to hike in December. Indeed, this is my core reason to suggest that a December hike should be considered the default position. Inflation has to be low enough (or employment gains have to wane) to force them to wait. Otherwise, they are hiking.
The Market Thinks This Is Dovish
I get why, but I don't really agree. The odds of a December hike (according to fed funds futures) has fallen to 33%. I still think the odds should be about 50/50. Just because the Fed is paying attention to low inflation doesn't mean inflation will stay low all the way through December. Like I said, I think basically any rebound in core PCE gets the Fed back on track. I'm comfortable saying the odds of a slight rebound in inflation are about 50%.