Fed Reaction Function: Takeaways From May FOMC Minutes

An overweight to US rates has been a high-conviction position for Western Asset this year. The position is based on three related views: US growth would not accelerate materially, inflation risks would continue to be to the downside and the Federal Reserve’s (Fed) reaction function would be less hawkish than feared.

This week the Fed released the minutes from the May meeting of the Federal Open Market Committee (FOMC). The minutes offer a well-timed opportunity to reassess the third part of our view and kick the tires on the Fed’s reaction function. As it was, the minutes contained no hint of the hawkishness that many fear. On the contrary, the tone of the FOMC minutes was dovish on at least three accounts, each outlined below. Our view continues to be that the Fed will be less hawkish than feared, and the FOMC minutes released this week support that view.

Arguments for Hawkish Policy Have Receded to the Background

Over the past few years there have been a number of justifications offered for more hawkish monetary policy. A few years ago, Fed officials worried about financial stability risks due to elevated asset prices. Recently, the falling unemployment rate has attracted attention as a potential “risk” that may warrant tighter monetary policy. Importantly, these concerns appear to have receded into the background at the most recent meeting. The May FOMC minutes downplayed such hawkish arguments, and instead highlighted a number of counterarguments that would have dovish implications.

The discussion around the unemployment rate is of particular note. The fact that the unemployment rate is now below the Fed’s estimate of the long-term rate has been cited as a reason why the Fed may need to tighten policy. Implicit in that concern is a notion that somehow a low unemployment rate will spark a sharp uptick in inflation. We have not found this argument very compelling. The unemployment rate has not been particularly useful as an indicator of future inflation. Inflation fell less than expected when the unemployment rate spiked in 2008 and 2009, and then inflation rose only slightly as the unemployment rate plummeted since 2010. Other indicators suggest that slack remains in the labor market. Wage growth remains below 3%, and the employment-to-population rate is still below levels attained during previous cycles. We have argued, therefore, that the unemployment rate can remain below the Fed’s estimate of the long-run rate for some time yet to come. The May FOMC minutes acknowledge that possibility, and did not convey any particular alarm about such a scenario. The lack of concern is a change in tone, albeit somewhat subtle, from previous communications.

It has been odd to hear people worry about the unemployment rate dropping too much. The Fed has a mandate of “full employment” and for years has been working to support further gains in the labor market. A lower unemployment rate is something that should be welcomed as a sign of the Fed fulfilling its mandate. Concerns about higher inflation are, of course, valid and worth discussing. After all, the second part of the Fed’s mandate is to maintain stable prices. However, the link between the two is much less immediate than often portrayed, and the two issues should be clearly distinguished. It is refreshing to hear the Fed taking a more sanguine view of the labor market, rather than the misguided one that a lower unemployment rate, in and of itself, is somehow a problem.

Could an Inflation Overshoot Be “Helpful” for the Fed?

The official statement released after the May FOMC meeting emphasized that the Fed’s inflation objective is “symmetric” around 2%. The official statement now includes the word “symmetric” in two different places, clearly signaling that this is an important point for the Fed. Given that for the past few years realized inflation has been persistently below 2%, a “symmetric” objective can only mean that the Fed would tolerate inflation being somewhat above 2% in the future. At the time of the release we, and many others, took the emphasis on symmetry as a reassurance that the Fed would not overreact if inflation were to move above 2%.

The May FOMC minutes took this line of argument one step further. Here is the key sentence (emphasis added):

There is an important difference between tolerating inflation above 2% and actively pursuing inflation above 2%. To be sure, the sentence above stops short of saying that having inflation above 2% is now the official goal. (And it also does not mention how many FOMC members hold this view, instead saying only that “it was noted.”) Nevertheless, by acknowledging that higher inflation could be “helpful,” this sentence certainly leans in the direction of aiming for an inflation overshoot. That is an important shift for the FOMC.

There are at least two deeper issues behind this shift in direction. The first is that inflation expectations are an important part of the Fed’s model for what generates future inflation. As has been seen in Europe and Japan, if inflation expectations move too low, it can be incredibly hard to get them back up. The Fed is keenly aware of this challenge, and is therefore intent on keeping inflation expectations close to, if not slightly above, its 2% target. A second issue is the simple math behind having a symmetric 2% inflation target. At some point there will be an economic downturn (we think that time is a ways off, but that’s a different discussion). It is likely inflation will fall below 2% when that occurs, as has happened in most previous recessions. Therefore, in order for inflation to be 2% on average over the business cycle, it needs to be above 2% during expansions to offset the time spent below 2% during contractions. That straightforward argument suggests the Fed needs inflation above 2% now in order to have inflation expectations reflect an average of 2% going forward.

Interest Rates May Be at Neutral “Before Too Long”; After That the FOMC Aims at “Sustaining the Expansion”

The most important debate within the FOMC is not about raising interest rates at the next meeting or two. That appears to be all but settled, and the market is already priced for it. Instead, the more important debate is what to do toward the end of the interest rate hiking cycle. That includes the question of when the Fed will reach neutral policy, as well as the question of what to do once neutral is reached. The May FOMC minutes shed some light on these questions. In particular, the minutes suggested that “neutral” may be closer than many appreciate. They also reaffirmed that after reaching neutral, the Fed has no interest in prematurely ending the business cycle. Instead, the FOMC reaffirmed that its goal will be to “sustain the economic expansion.”

The level of neutral policy is practically impossible to estimate. Neutral policy is defined as the interest rate that neither stimulates nor dampens economic growth. Obviously this depends on a great number of factors, including the broader economic and financial environment, many of which are themselves very tough to measure. The difficulties in measurement and estimation do not prevent the FOMC from trying. Indeed, the importance of the issue requires the committee to keep at it, if only to have a rough guide for the actions.

The surprising bit of the May FOMC minutes was that “a few participants” believe interest rates will reach neutral “before too long.” These participants argued that the neutral level of interest rates may be currently below its longer-run level, implying that a fed funds rate of 2.25% could even be considered neutral in today’s environment. If correct, that means that following the anticipated hike in June, only one additional hike would bring policy close to neutral. That’s on the lower end. At the same time, certainly the four additional hikes that are currently priced into fed funds futures markets would represent the Fed hiking to, if not past, neutral. There is clearly a “range of views” within the FOMC on this issue, as would be expected with such a difficult debate. Nonetheless, the important point from the minutes is that the level of neutral policy may be closer than many had previously appreciated.

In contrast to the debate about the level of neutral, there appears to be more consensus within the FOMC on what to do upon reaching neutral. The FOMC minutes note that: “Participants indicated that the Committee…should conduct policy with the aim of keeping inflation near its longer-run symmetric objective while sustaining the economic expansion and a strong labor market.” This may seem like standard Fed rhetoric, but it was included in the FOMC minutes for a reason. It is intended as stark refutation of those fearing the Fed will adopt an overly hawkish policy that would prematurely end the business cycle. The statement could not be more straightforward: a primary goal is to “sustain the economic expansion.” The most obvious way to sustain the economic expansion would be to keep policy at neutral. It is not at all clear how tightening past neutral would help achieve that goal. Equally important is what is not included in the statement of objectives. Nowhere does the Fed say that the goal would be to get interest rates as high as possible, so that they can be cut in response to a coming recession. Instead, the objective will be to avoid, or more realistically to significantly delay, a recession by conducting appropriate policy.

Taken as a whole, the discussion of how to conduct policy as interest rates continue to increase had a decidedly dovish tilt. Of course a change in environment, and in particular a surge in inflation, could alter the Fed’s thinking. But, for the moment, the FOMC is flagging the possibility that neutral policy may be reached “before too long,” and once there the aim will be to “sustain the expansion,” which could very well mean a pause or a halt to the rate-hiking cycle without ever tightening past neutral.

Conclusion

Since the beginning of the year the market has sharply reassessed its expectations for Fed policy. Part of the reassessment is likely due to an increase in forecasts for 2018 growth, which in turn is related to an expected fiscal boost that could temporarily raise GDP above the 2.0% to 2.25% trend that has characterized the last few years. But, that’s only part of it. Forward interest rates have seen some of the sharpest increases. For example, the expected rate on 5-year swaps five years forward has increased by almost 50 basis points since the beginning of the year.

Such a sharp increase in forward rates can only be justified if the anticipated 2018 growth boost leads to a sustained improvement in growth and inflation, and if that change in regime causes the Fed to pursue more hawkish policy as a consequence. We are skeptical that a transitory fiscal boost will affect the long-term trend. And we are even more skeptical that the Fed reaction function has changed in such a way that it would now be appropriate to expect a hawkish policy stance. The May FOMC minutes that were released this week provided an opportunity to reassess the Fed reaction function. As a result, we see little reason to change our view that the Fed will be less hawkish than feared. On the contrary, there were many parts of the minutes that reaffirm our view of the Fed’s caution in the face of what is still a very uncertain outlook.