October FOMC minutes – eyes on inflation compensation

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There were few surprises in the October 28-29 meeting minutes published on 19/11/14. As was reflected in the statement, the Federal Open Market Committee (FOMC) continues to have a relatively upbeat view of the growth outlook and generally sees limited negative consequences of slower growth abroad. The key passage on this topic notes that “many participants saw the effects of recent developments [abroad] on the domestic economy as likely to be quite limited”, due to the small contribution of external trade to the US economy, modest effects of dollar appreciation on net exports, and structural shifts in US trade and production. Also, to the extent that weak foreign growth and a stronger dollar would restrain US growth, “several participants” thought the impact would be offset by lower commodity prices and long-term interest rates.

If the growth outlook has not shifted much, neither has the inflation outlook. As with prior communications, there are some concerns about downside inflation risks, but it would take quite a bit of hair-splitting to make a convincing argument that concerns are meaningfully more elevated now than they were at the September meeting. As was the case at the September FOMC meeting (click here to read my note on the September meeting), there remain some on the FOMC who are concerned that inflation will struggle to achieve the 2% objective within a reasonable time frame. In that vein, meeting participants had a healthy discussion over the decline in market-based measures of inflation compensation (Click here to read a speech by Federal Reserve Bank of New York President William C. Dudley in which he dismissed the drop in market-based (as opposed to survey-based) measures of inflation expectations).

One of the main distinctions the FOMC is attempting to make, is whether this decline reflects a fall in expected inflation, or a shift in the distribution of outcomes towards lower inflation (i.e. a decline in the inflation risk premia). The New York Fed asked us and other market participants this very question in their pre-meeting survey. I suspect that the survey results, published tomorrow, will reveal that most investors viewed the decline in in 5-year, 5-year (5y5y) forward break even inflation rate (BEI) (see Figure 1) as a result of declining risk premia, and not inflation expectations. However there is a risk that the FOMC takes too much comfort in this interpretation. The decomposition of BEIs into expected inflation and risk premia may reveal that expectations have remained stable, but a declining inflation risk premium nonetheless still indicates that investors are assigning more weight to low-inflation outcomes. Should this continue, I would expect modal inflation expectations to eventually shift lower as well. We are already starting to see some down-drift in inflation expectations in some of the survey measures.

Figure 1: 5-year, 5-year forward break even inflation rate

While new information on the economic outlook was limited, there was a bit more meat on the bone when it comes to communications policy. There certainly appears to be a range of views on the merits of retaining “considerable time” to lift off in the statement for much longer. Some raised the standard concerns about the language not being sufficiently time-dependent, while others noted that its removal might be interpreted as a meaningful policy shift that would lead to an unwanted tightening in financial conditions and a re-pricing of the timing of lift off. I believe that core FOMC members are firmly in this later camp, which implies that “considerable time” may stay in the statement until first quarter next year. As Stanley Fischer has noted, a “considerable time” may be as short as two months.

Finally, the head of operations at the New York Fed briefed the FOMC and Board of Governors on what appears to be a potential new exit tool that would use funds held at the Federal Reserve by depository institutions as collateral in draining operations. The reference is extremely vague – we’ll need to look to speeches or possibly an operating statement from the New York Fed for greater detail.

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