Lags And Stepdowns

The word “lags” came up nine times in the November FOMC minutes, released into a pre-Thanksgiving void on Wednesday.

The market’s initial reaction was to trade the account of this month’s gathering with a dovish bias, but I’d argue the price action was largely meaningless.

Traders, carbon-based and otherwise, were keen to discern unanimity around the so-called “step-down” narrative, introduced in mid-October by Wall Street Journal “Fed whisperer” Nick Timiraos, who suggested the Committee was poised to convey a predisposition to a slower pace of rate hikes following a fourth consecutive three-quarter point move this month.

Although the new policy statement appeared to confirm the narrative, Jerome Powell made clear in remarks to reporters that the tradeoff was a higher terminal rate versus that tipped by projections released in September. Over the ensuing three weeks, market pricing ebbed and flowed as traders weighed a cooler-than-expected read on October inflation against official rhetoric which overwhelmingly suggested policymakers wanted no part of the historic easing in financial conditions catalyzed by the relatively benign inflation print.

The key passage from the November minutes read as follows:

Participants mentioned a number of considerations that would likely influence the pace of future increases in the target range for the federal funds rate. These considerations included the cumulative tightening of monetary policy to date, the lags between monetary policy actions and the behavior of economic activity and inflation, and economic and financial developments. A number of participants observed that, as monetary policy approached a stance that was sufficiently restrictive to achieve the Committee’s goals, it would become appropriate to slow the pace of increase in the target range for the federal funds rate. In addition, a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate. A slower pace in these circumstances would better allow the Committee to assess progress toward its goals of maximum employment and price stability. The uncertain lags and magnitudes associated with the effects of monetary policy actions on economic activity and inflation were among the reasons cited regarding why such an assessment was important. A few participants commented that slowing the pace of increase could reduce the risk of instability in the financial system.

There’s no “new” information there, but the “substantial majority” bit was notable, as was the nod to financial stability risks, which “several participants” said might grow in the face of “continued rapid policy tightening.”

The Committee is keen to foster consensus, and unanimous decisions are obviously their preference, but it’s fair to suggest there’s considerable disagreement currently around what counts as “sufficiently restrictive.” Jim Bullard last week alluded to a “less generous” Taylor Rule approach that would open the door to rates near 7%, even as he didn’t necessarily advocate for adopting such a stance (in fact, he made a show of assuming a more generous application of the rule).

Although everyone at the Fed has apparently resigned themselves to a 5% terminal rate, the language from the minutes was somewhat soft in terms of conviction. “Various participants [said] the ultimate level of the federal funds rate that would be necessary to achieve the Committee’s goals was somewhat higher than they had previously expected,” the minutes said.

That read like a watered down version of the same general message conveyed by Powell earlier this month and reiterated since by his colleagues. What I’ve heard (and I imagine I’m not alone) is an unequivocal acknowledgment that the terminal rate tipped in September is now judged as too low. The language from the minutes is by no means inconsistent with that (in fact, it confirmed it), but “various participants” and “somewhat higher” sounded comparatively less assertive versus the ongoing/incoming messaging.

At the same time, “a few” participants suggested they wanted to see more data before slowing the pace of hikes. The same officials said it “could be advantageous” to wait until policy was “more clearly in restrictive territory” before dialing back the hike cadence. Nevertheless, there was something akin to broad-based agreement that as policy got closer to “sufficiently restrictive,” the pace would be less important than the level and “the evolution of the policy stance” once terminal is achieved.

There was some discussion of last month’s unfortunate events in the UK (i.e., the meltdown in gilts and near collapse of the nation’s pension complex triggered by Liz Truss’s ill-conceived growth plan). The Fed considered those events in the context of deteriorating liquidity in US Treasurys and the prospect of market functioning issues associated with ongoing tightening.

“The increased volatility appeared to contribute to a decline in measures of market liquidity in core fixed-income markets, in particular around the period associated with UK volatility, but market functioning remained orderly,” the minutes said.

“A few” participants emphasized that in the event of “disruptions in US core market functioning,” the Fed should be “prepared” to address the situation in a way that wouldn’t “affect the stance of monetary policy, especially during episodes of monetary policy tightening.” In other words: The Fed is cognizant that if things were to go awry at any point between now and “sufficiently restrictive,” it’d be imperative that any intervention not be construed by markets (or anyone else, for that matter) as tantamount to easing. (Good luck with that if it happens.)

Other selected highlights from the November minutes are below.

Nevertheless, many participants noted tentative signs that the labor market might be moving slowly toward a better balance of supply and demand; these signs included a lower rate of job turnover and a moderation in nominal wage growth. Participants anticipated that imbalances in the labor market would gradually diminish and that the unemployment rate would likely rise somewhat from its current very low level, while vacancies would likely fall.

Many participants observed that price pressures had increased in the services sector and that, historically, price pressures in this sector had been more persistent than those in the goods sector. Some participants noted that the recent high pace of nominal wage growth, taken together with the recent low pace of productivity growth, would, if sustained, be inconsistent with achievement of the 2% inflation objective.

Participants agreed that near-term inflation pressures were high, but some noted that lower commodity prices or the expected reduced pressure on goods prices due to an easing of supply constraints should contribute to lower inflation in the medium term. Several participants remarked that rent increases on new leases had been slowing in recent months, but participants also noted that it would take some time for this development to show up in PCE inflation.

A couple of participants discussed the high dispersion of longer-term inflation expectations across respondents in various surveys: These participants noted that the higher dispersion may signal increased uncertainty about the inflation outlook and was a reason not to be complacent about longer-term inflation expectations remaining well anchored.

Some participants noted the risk that energy prices could rise sharply again amid geopolitical tensions. A few participants commented that the ongoing tightness in the labor market could lead to an emergence of a wage–price spiral, even though one had not yet developed.

A number of participants judged that the risks regarding the outlook for economic activity were weighted to the downside, with various global headwinds being prominently cited. These global headwinds included a slowdown in economic activity occurring in China and the ongoing international economic implications of Russia’s war against Ukraine.