The Fed Continues Tapering; Tightening Still Seems Far Off

At its June meeting, the Federal Open Market Committee (FOMC) extended its predictable string of asset purchase reductions. Most of the attention was trained on an updated set of forecasts from the Fed that offers some clues to the future path of American monetary policy.

The statement that emerged from the meeting was little-changed from its April analog. The language continued to focus on inflation running below its 2% target, even though Tuesday’s release of the consumer price index (CPI) showed that measure had risen by more than 2% over the past 12 months. 

The Fed focuses more closely on a different inflation indicator – the deflator on personal consumption expenditures (PCE). That metric is rising about half a percent more slowly than the CPI, but it is rising. Janet Yellen suggested that the inflation data remain “noisy,” adding that the price level is progressing in line with the Fed’s expectations. 

She also reiterated the possibility that inflation could be allowed to run slightly above target for a time, in the name of pursuing better results in the labor market. We’ll have more on this topic in Friday’s weekly commentary.

The central tendency in the FOMC’s collective forecast now calls for 2014 growth in real gross domestic product (GDP) of 2.1% to 2.3%, down from 2.8% to 3% in the March projections. But much of the decline in expectations for this year is due to the influence of a very soft first quarter. Expectations for 2015 and 2016 GDP growth remained unchanged. Near-term unemployment expectations were lowered to reflect the drop in joblessness seen over the past several months. 


Interestingly, the consensus now anticipates that the unemployment rate will fall below its long-term potential level in 2016. This may explain why only three of the 16 contributors to the FOMC forecast think that overnight interest rates should stay near zero through the end of next year. Among this community, the median expectation for the Fed funds rate at the end of 2015 stands at around 1.25%; the futures market currently implies a rate of only 80 basis points.


FOMC Expectations for Overnight Rates

There was a very modest reduction in the median estimate of the longer term funds rate. Some will attempt to read this as acknowledgement that policy will have to remain easier for longer than previously thought, but it could also reflect the changing mix of FOMC participants. 

There were three new faces at the table for this meeting and two old faces which were not. After a flurry of last-minute approvals by the Senate, Stanley Fisher was seated as vice chairman of the Board of Governors, which now includes Lael Brainard. (Governor Jerome Powell was also confirmed for another term on the Board.) Loretta Mester, the new president of the Federal Reserve Bank of Cleveland, joined the FOMC as a voting member for the first time. 

These additions are not expected to change the Fed’s philosophical center of gravity. All are accomplished scholars and policy-makers, and none are expected to make an early break from the current consensus. The vote in support of today’s action was, in fact, unanimous. 

It will certainly be helpful to have a few more hands on deck to share the work of running the central bank, although it remains a disappointment that operating with five of seven Governors has become such a norm over the past decade. 

The statement indicated that risks to the outlook were balanced. Chair Yellen indicated that low levels of market volatility are “on her radar screen.” She noted signs of reaching for yield but considered current risks to financial stability as very moderate. No specific mention was made in the FOMC statement of rising energy prices or international uncertainty. 

The FOMC agenda also included continued discussion of how the Fed might diminish its accommodation when the time comes. Chair Yellen took care to note that this should be viewed as prudent planning, not a sign of imminent change. More details were promised later this year. 

We’d offer a couple of thoughts on this topic:

  • We expect the Fed to continue reinvesting maturing securities for some time to come. This will keep downward pressure on mortgage rates, providing help to a housing sector that has lost quite a bit of momentum recently.
  • We think that the Fed’s reverse repo facility, which is relatively new, will be central to the process of draining reserves. The size and maturity of the program can be closely tailored, it allows the Fed to avoid selling its securities holdings, and it is cost-effective. It also has some advantages for banks that must comply with international liquidity standards.

As we have said in the past, it would take a pretty substantial deviation in the outlook to interrupt or accelerate the current pace of asset purchases. With just a few meetings to go before the program might stop, attention surrounding the next phase is rising. The outlook holds the key to the timing and tactics of that transition.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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