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August 29, 2006
FOMC Minutes
The minutes of the August FOMC meeting are out. While they tell a story that we already know a great deal about, they do fill in a couple of gaps in what we know about what the Fed is thinking.
Some selected paragraphs that convey the message...
The staff forecast prepared for this meeting indicated that real GDP growth would slow in the second half of 2006 and 2007, and to a lower rate than had been anticipated in the prior forecast. The marking down of the outlook was largely attributable to the annual revision of the national income and product accounts, which involved downward revisions to actual GDP growth in prior years and prompted reductions in the staff’s estimate of potential output. The slowdown in the housing market, the effects of higher energy prices on household purchasing power, the waning impetus of household wealth effects on consumer spending, and the effects of past policy tightening were expected to hold economic growth below potential over the next six quarters. Core consumer price inflation was projected to drop back somewhat later this year and next, mainly as the effects of higher energy and import prices abated.
The fact that their forecast has been revised downward recently is significant. It was a close call anyway, and a downward revision could easily tip the scales for a lot of people. Further down the minutes...
Some participants noted that global demand remained strong, potentially adding to worldwide pressures on resources. Increased geopolitical risks, particularly related to developments in the Middle East, continued to put pressure on energy prices, and the prices of many other commodities also had firmed over the intermeeting period. Central banks had been raising interest rates globally, however, and this was viewed as a factor that should help to restrain global inflation pressures. But it was also noted that the recent decline in the foreign exchange value of the dollar could lead to a weakening of import competition in the form of increases in the prices of tradable goods in the United States.
See also: Dance of the bankers. One cannot ignore the fact that other central banks are raising rates. Global markets are integrated well enough that it could lead to exactly what they suggest in the last sentence. And that would mean... you guessed it.
As at the June meeting, all participants expressed concern about continued elevated readings on core inflation and inflation risks going forward. Several participants took note of the revisions to historical data that painted a more worrisome picture of cost trends; measures of unit labor costs had been marked up, reflecting upward revisions to labor compensation and downward revisions to labor productivity. Core PCE inflation now appeared to have been running at or above a 2 percent annual rate for more than two years, with prices accelerating over the first half of 2006. Many participants noted that the extent to which the increase in core inflation so far this year reflected transitory or persistent influences remained unclear. The recent pickup in price increases appeared to be broad-based, and a number of business contacts reported greater ability to pass through higher costs. However, some types of price pressures were not likely to continue to increase. The recent acceleration in shelter costs, which contributed substantially to the increase in core inflation this year, could prove short-lived. Moreover, while energy prices had risen further in the intermeeting period, energy prices could well level out in coming quarters. Also, the anticipated moderation in aggregate demand implied that pressures on resource utilization likely would not increase and could abate to a degree going forward. Finally, inflation expectations appeared to have remained contained despite adverse news about prices. In light of these factors, most participants expressed the view that core inflation was likely to decline gradually over the next several quarters, although appreciable upside risks remained.
In the Committee’s discussion of monetary policy for the intermeeting period, nearly all members favored keeping the target federal funds rate at 5-1/4 percent at this meeting. In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed. But with economic growth having moderated some, most members anticipated that inflation pressures quite possibly would ease gradually over coming quarters and the current stance of policy could well prove to be consistent with satisfactory economic performance. Under these circumstances, keeping policy unchanged at this meeting would allow the Committee to accumulate more information before judging whether additional firming would be necessary to foster the attainment of price stability over time. The full effect of previous increases in interest rates on activity and prices probably had not yet been felt, and a pause was viewed as appropriate to limit the risks of tightening too much. Following seventeen consecutive policy firming actions, members generally saw limited risk in deferring further policy tightening that might prove necessary, as long as inflation expectations remained contained.
All members agreed that the statement to be released after the meeting should convey that inflation risks remained dominant and that consequently keeping policy unchanged at this meeting did not necessarily mark the end of the tightening cycle. They concurred that an indication that economic growth had moderated was appropriate, and a consensus favored citing the same reasons for that moderation as in the June statement. Members also agreed that the statement should both mention factors contributing to the likely moderation of inflation pressures over time and reiterate the forces that were seen as having the potential to sustain inflation pressures.
Though rather lengthy, I quote it all because each sentence has significance. Overall, I get the picture that despite the fact that inflation has been running high, and energy prices have not abated yet, the slowing of economic growth should be enough to take the pressure off. If they are correct that energy prices will level off and core inflation at least does not accelerate further, they will have timed everything about right. They recognize the policy lags that have been in alternating between the front and the back of my mind for the last year. To put it succintly, they are betting that they are not behind the curve and hoping that they are a little ahead of the curve if there is to be a coming disinflation (albeit a slight disinflation). But it seems to hinge a lot on the revised forecast and the impression that growth is slowing. Yet when talking about inflation, they use words like:
The recent acceleration in shelter costs, ... could prove short-lived.
...energy prices could well level out...
...could abate to a degree...
Finally, inflation expectations appeared to have remained contained despite adverse news about prices.
The last is really quite a statement about the confidence in the Fed's ability to fight inflation should things get even worse. No small feat. But note that when it comes to inflation, there is heavy use of words like "could" and "appeared" and the like. That is telling. Inflation is, right now, the real wild card in the game. We do not know what is going to happen next. It "could" turn out ok, but the risks are palpable. Slowing growth, on the other hand, is becoming more and more of a fact. Whatever our deep-down feelings are about Phillips curves might be, most of us do accept that, ceteris paribus, slowing growth on the demand side does temporarily take some pressure off of inflation.
But as they say, ceteris is not always paribus.
And further down we see a short explanation of Mr. Lacker's dissent.
Mr. Lacker dissented because he believed that further tightening was needed to bring inflation down more rapidly than would be the case if the policy rate were kept unchanged. The inflation outlook had deteriorated in the intermeeting period; the recent surge in core inflation had persisted and appeared to be broad-based, while the revision of the national income and product accounts indicated a recent upswing in compensation and unit labor costs. Although real growth was likely to be somewhat lower in coming quarters, in his view it was unlikely to moderate by enough to bring core inflation down. He noted, moreover, that real short-term interest rates had fallen in the intermeeting period and were still low relative to rates typically associated with sustained expansions.
Similar concerns were expressed by Martin Feldstein. I have noted my own concern over real interest rates here and here. This seems to be Mr. Lacker's concern as well. If you get behind the curve, nominal interest rates need to go even higher than they otherwise would because you need to get the real rates (pushed down by surging inflation) up. As just about all of us have said at one time or another, this is a really tough call. The entire episode reinforces the fact that the Fed is concerned enough about the slowdown (in all likelihood influenced by their revised forecast) that they are willing to take what any central banker knows is a risk. Not being privvy to the forecast and everything else that was said in the room, I'm prepared to give them the benefit of the doubt to a certain extent. But it is clear from the minutes that the market should not interpret this as the end of the hikes. Let's hope it doesn't put them behind the curve.
Finally...
The Committee then turned to a discussion of the goals and principles that should guide the review of its approaches to policy communications that it had recently undertaken. Participants agreed that communication was important for democratic accountability and could promote the effectiveness of policy. Although considerable strides had been made in FOMC communications over the past ten years or so, participants generally thought that further advances were possible. In that regard, consideration of how the Committee expressed both its economic objectives and its assessments of expected progress toward those objectives was likely to be particularly important. Conveying the degree of uncertainty and conditionality about Committee expectations of future developments was seen as a major challenge. It was recognized that communications should support appropriate decisionmaking, including respect for the diversity of views that contributed to good decisions. Participants agreed to continue the Committee’s review of communications issues at the FOMC meeting in October.
That is a nice note on which to end the minutes. I look forward to the transcript of this in five years. I'm sure they realize that calling it a "major challenge" is quite an understatement. While "impossible" might be too strong, they do have their work cut out for them. I am hopeful that they will learn from the "measured pace" episode and be more aware that certain catch phrases can take on a life of their own. Everyone needs to remember that transparency in the process does not imply certainty over the outcome.
UPDATE: CNNMoney reports:
Economists are mixed since it all depends on which portion of the minutes you find most important. You can clearly make a case for why the Fed will hold pat in September or why the central bank will once again raise rates.
"Clearly" might be a stretch. My read of the situation at present is that the default position for the next meeting is to keep rates unchanged and that it will take some unexpected spike in inflation data to move them off that position. While I share Lacker's concern that inflation and inflation expectations could become entrenched if they are not careful, I would not necessarily predict that the next data point in particular will cause them to reverse course. It depends on whether you are thinking 3 weeks or 3 months ahead. So for now I would look for no change at the next meeting unless something pretty drastic happens in the inflation data. But looking out over the next few months, more rate hikes could be on the way if inflation doesn't abate as it "could".
Posted by William Polley at August 29, 2006 4:20 PM
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