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FOMC in search of neutral – Westpac

Elliot Clarke, Research Analyst at Westpac, suggests that the minutes from FOMC May meeting caught the market off guard, with the 10-year US yield falling from 3.06% ahead of the release to 2.98% the day after – the cancelation of the US/ North Korea summit was also a factor here.

Key Quotes

“The surprise for markets (or at least those talking up inflation risks of late) was the calmness shown by the Committee.  Rather than seeing the risk of a break higher in PCE inflation above 2.0%yr towards the CPI’s 2.5%yr current level, the Committee instead held that it was “premature to conclude that inflation would [even] remain at levels around 2 percent”.  This view is seemingly based on “some of the recent increase in inflation” being representative of “transitory price changes” and as ”various measures of underlying inflation, such as the 12-month trimmed mean PCE inflation rate from the Federal Reserve Bank of Dallas, remained relatively stable at levels below 2 percent”. To see upside inflation risks build, a stronger wage inflation pulse is necessary. At present the employment cost index is only reporting “a gradual pickup in wage increases”, while the uptrend in other measures is “less clear”.”

“For those who doubt this view of inflation and instead anticipate it will sustain above 2.0%yr, the use of “symmetric” 10 times in the minutes cautions on the impact such an upside surprise would have on policy. Put simply, even if inflation does surprise to the upside and exceed 2.0%yr for a time, the Committee are likely to look through it, seeing such an episode as transitory and potentially needed to sure up long-term inflation expectations following such a long period of failure in achieving the target. An acceleration in the pace of rate hikes would only be seen if inflation accelerated away from the FOMC’s medium-term target.”

“The second important aspect of recent FOMC communications is their view of financial conditions and neutral. Broadly on financial conditions, these are seen as supportive of growth, with a US dollar well below its 2016 peak and equity markets near highs offsetting a return of the 10-year yield (and thus mortgage rates) back to their 2013 highs.”

“The more significant point is that, now ‘neutral’ is nearing, the Committee is becoming more concerned over the potential for a non-linear response in financial conditions and/or growth from a rate hike(s). Whereas their longer-run expectation of the fed funds rate is 3.00% (from the March meeting forecasts), speeches made by regional Fed Presidents Harker, Kaplan and Bostic after the minutes release point to neutral currently being around 2.50–2.75%. President Williams of the San Francisco Fed (soon to be the NY Fed) update on R-star this week corroborated this view, seeing it stuck around 2.50%.”

“A perceived neutral rate of 2.50% and lingering doubts that inflation will run above the 2.0%yr target are supportive of our view that this FOMC hiking cycle will end after four further hikes in mid-2019 at 2.625% – well short of the FOMC’s seven hikes to the 2020 forecast, as per the March 2018 meeting forecasts. There is an additional element worth keeping in mind in all of this. The FOMC want to promote confidence in the economic and policy outlook. To do that, a positive sloped yield curve is strongly desired (to stop concerns of a recession developing). As such, expect short-term caution to be strongly emphasised by the FOMC, but those longer-term rate hike expectations to remain in place.”