December FOMC Meeting: where is the inflation?

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As markets had widely expected, December’s FOMC meeting raised the target range for the US federal funds rate by 25bp to 1.25%-1.50% and made only modest changes to the post-meeting statement.

Importantly, the Summary of Economic Projections (SEP) by US monetary policymakers now more fully factors in the upcoming fiscal stimulus, with the median growth projection for 2018 being revised up by four-tenths of a percent to 2.5%. The 2019 and 2020 projections saw more modest increases (see Exhibit 1 below).

With a stronger growth impetus, the projections for the unemployment rate for each of the next three years were revised lower by two-tenths of a percent. Yet despite the stronger growth and labour market outlook, there was remarkably little change to the inflation expectations.

Not only did the median projections remain unchanged throughout the forecast horizon, but only in the full range of submissions by all participants in the FOMC meeting do we see any evidence of a few committee members marking up their inflation outlook, and then only modestly.

Exhibit 1: Economic projections published after FOMC meeting in December 2017

Stronger growth, but stable inflation projections could reflect a view that trend growth is higher, or NAIRU (the Non-Accelerating Inflation Rate of Unemployment) lower, than previously thought. But interestingly, these longer-run projections did not change from the September projection round.

Another possibility is that a steeper projected path for policy interest rates could bring growth back towards trend and limit any inflation pressures. But the median projected path is unchanged through 2019 and there is just a modest 20bp upward revision to the 2020 median rate projection (Exhibit 2).

Fed Chair Janet Yellen was asked about this seeming inconsistency in the projections in the press briefing and her response suggests less confidence in a Phillips curve framework, or that the framework remains valid, but the curve is and will continue to remain quite flat: “inflation has run lower than we expect, and it could take a longer period of a very strong labor market in order to achieve the inflation objective.”

Exhibit 2: The projected path for US interest rates is unchanged through 2019 with just a modest 20bp upward revision to the 2020 median rate projection

Chair Yellen was also cautious in her characterisation of the inflation outlook at other points in the press briefing, even as she reiterated her view that inflation has been held down by transitory factors that are likely to fade over time.

She noted that low inflation “could end up being something that is more ingrained”, that assessments of NAIRU may need to come down further, and that inflation expectations may have slipped.

These considerations may explain why the FOMC meeting remained hesitant to mark up its anticipated rate path despite further projected declines in the unemployment rate to well below their NAIRU estimate (Exhibit 3).

Exhibit 3: The unemployment rate is projected to fall to well below the NAIRU estimate

Overall, the Chair’s comments suggest that the committee will remain quite cautious in continuing to raise rates in 2018 absent clear evidence of inflation picking up, even if the unemployment rate falls further.

We continue to expect 100bp of tightening in 2018 on the view that core PCE inflation will firm (but remain short of the inflation objective), while the unemployment rate falls to around 3.5%. But if the committee’s concerns about lower trend inflation and inflation expectations are becoming more pronounced, the risks to our call are certainly skewed toward fewer rate increases.

Elsewhere in the press conference, Yellen elaborated on how the committee assessed the impact of fiscal stimulus on the economy.

Her comments suggest that the committee remains somewhat skeptical that the upcoming tax package will meaningfully impact trend growth: “So, I think my colleagues and I mainly see the likely tax package as boosting aggregate demand, but also having some potential to boost aggregate supply… a stronger pace of investment could …raise productivity growth and potential GDP or output to some extent. Exactly how large those effects might be remain uncertain”.

At this point, the FOMC remains open to the possibility that the tax package could meaningfully change the supply picture, in which case the committee might be less inclined to lean against strong growth with tighter policy.

But at least judging by Yellen’s comments and the full range of projections for the economy’s longer-run growth rate, the majority of FOMC meeting participants are not yet making any revisions to their trend growth assumptions as a result of the likely tax cuts.

Written on 15/12/2017

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