In a note released overnight, Goldman chief economist Hatzius writes that “despite sharply weaker core inflation in the last two months, we continue to expect rate hikes in June and September followed by an announcement of balance sheet runoff in December, as well as a funds rate path well above the forwards in 2018 and beyond.” And while he said that the firm has not “made any changes to these forecasts because the negative inflation surprise has coincided with a roughly equivalent upside labor market surprise” he adds that “the risk to our near-term funds rate view is now slightly greater, largely because the range of plausible outcomes has widened. We have shaved our subjective odds of a June rate hike to 80%, from 90% earlier, and have also become a bit less confident in a September hike. If the outlook deteriorates significantly, the committee might simply delay any further tightening steps.”
What does this mean for the sequence of proposed events between the Fed’s potential balance sheet reduction announcement and future rate hikes: according to Hatzius it means that “even a more modest deterioration could prompt the committee to pull forward the announcement of balance sheet runoff to the September meeting and delay the third 2017 rate hike until December.”
To provide further color on Goldman’s changing thinking, Hatzius has expressed his thought in the now traditional self-Q&A format as laid out below.
Q: What is the latest on core inflation?
A: Friday’s CPI report was another meaningful downside surprise. Cumulatively, the year-on-year rate of core CPI inflation has fallen 0.33pp, from 2.22% in February to 1.89% in April. Not all of this weakness will feed through into the core PCE index, but we have lowered our Q4 estimate to 1.8%, from 2.0% two months ago.
Q: Have you made any changes to your baseline monetary policy call for 2017 in response to this surprise?
A: No. Our baseline forecast remains a hike in June, a hike in September, and a turn to balance sheet runoff to be announced in December.
Q: But won’t the FOMC respond to the weaker inflation numbers by hiking less?
A: Not necessarily, because the downside inflation surprise has been accompanied by a significant upside labor market surprise. The unemployment rate has fallen by 0.3pp in the last two months and already stands 0.1pp below the FOMC’s median yearend estimate of 4.5%. Moreover, other indicators such as U6, the employment/population ratio, continuing unemployment claims, and payroll growth all tell a similar tale of ongoing sizable labor market improvement. On net, we have therefore reduced our unemployment rate forecast by 0.1pp in 2017 and 0.2pp in 2018, with risks that are probably still on the downside.
Q: So the surprises are of roughly equal magnitude. Which one is more important?
A: We view them as similarly important. A simple way to make this point is via a standard Taylor rule framework. If we assume that each 1% increase in output equates to a 0.5pp decline in the unemployment rate, the original Taylor rule implies that a 0.2pp reduction in inflation lowers the appropriate funds rate by 30bp while a 0.2pp reduction in the unemployment rate raises the appropriate funds rate by 20bp. In a modified “Taylor 1999” rule, the impact of output and employment is doubled relative to the original version. This means that the impact of a 0.2pp reduction in unemployment rises from 20bp to 40bp. So if the committee puts some weight on both versions of the Taylor rule, the surprises should have roughly offsetting effects.
Q: But doesn’t the weakness in core inflation also tell us that the structural unemployment rate might be lower?
A: Yes, in theory, but we would be cautious about this argument in practice. For one thing, more than half of the 0.33pp drop in the year-on-year core CPI from February to April was due to the cell phone services category. And almost all of this weakness resulted from methodological changes, which means that it provides no new information about structural unemployment.
More generally, one should be cautious in “backing out” structural unemployment from the behavior of core CPI/PCE inflation alone, given how poorly the Phillips curve fits the data. This is especially true at a time when other, related indicators tell a different story. For example, our wage tracker stands at 3.0%, close to our 3¼% estimate of the pace consistent with full employment; unit labor costs in the nonfarm business sector are up 2.8% year-on-year, above the 2% rate that is sustainable in the long term; and even the price signals are somewhat mixed, as the core final-demand producer price index has beaten expectations recently and now stands at 1.9% year-on-year, the highest level since 2014.
Q: So your baseline monetary policy view hasn’t changed. What about the confidence with which you hold this view?
A: It has declined slightly because the conflicting signals on inflation and employment imply that the range of plausible outcomes is arguably greater than before. If the inflation weakness reverses, Fed officials might accelerate the tightening process because of increased worry about labor market overheating. Conversely, if job growth slows and the unemployment rate rebounds, they might pause the normalization. A wider range of outcomes implies that the probability of any given outcome is lower than before.
Q: Have you changed your subjective probability of a hike in June?
A: Yes, we have shaved our subjective odds from 90% to 80%. A hike is still the most likely outcome by a sizable margin, partly because we have not yet seen much evidence that more dovish participants are pressing for a change in the committee’s strategy. (The exception is Minneapolis Fed President Kashkari, who dissented against the March hike and has continued to press the case for continued accommodation.) That said, it has become more conceivable that developments between now and June 14—e.g. a large disappointment in the May employment report that calls into question some of the earlier progress—might persuade the committee to hold fire after all. (The May CPI is not released until the morning of the second day of the FOMC meeting and is less likely to affect the decision.)
Q: How confident are you about September?
A: Although we currently do not provide explicit monetary policy probabilities beyond the next move in the funds rate, we have become slightly less confident about a September hike as well. If the outlook deteriorates significantly, the committee might just delay any further tightening steps. And even in the absence of a significant deterioration, a September hike is not assured, as we now see a slightly better chance than before that the committee pulls forward the announcement of balance sheet runoff to the September meeting and delays the third 2017 rate hike until December (although we emphasize that this is not our baseline view).
Q: Why might they reverse the order?
A: We see three potential reasons. First, our analysis suggests that the announcement of balance sheet adjustment is a smaller tightening step than a 25bp rate hike, and this is consistent with the subdued market response to the recent shift in the committee’s balance sheet guidance. If the committee is skittish about tightening too much at the September meeting but wants to retain the optionality of delivering three hikes in 2017, reversing the ordering of the third hike and balance sheet runoff might make sense.
Second, mid-September could be a time of high anxiety about the fiscal policy outlook. The federal government could partially shut down from October 1, the start of the new fiscal year, if spending legislation has not been passed by then. Moreover, the debt limit is likely to become a constraint on Treasury borrowing around the same time, probably in early October (this date is fluid and could come as soon as August but no later than October). These deadlines are likely to be taken a bit more seriously this year than they have been over the last few years, as bipartisan support will be necessary for passage but could be difficult to achieve; policy differences between the Trump Administration and congressional Democrats will be difficult to resolve, and concerns over the state of ongoing investigations into foreign influence in the recent election, if they continue, could make a resolution even more difficult.
Third, several FOMC participants have recently hinted at a start to balance sheet runoff that could come earlier than the December meeting. For example, Boston Fed President Rosengren said on May 10 that he favors a beginning of balance sheet runoff after the next funds rate hike, i.e. in September. Moreover, Chicago Fed President Evans gave an interesting response to a question about the balance sheet on May 12: “[M]arkets always want to know we’re going to do this at this day or time, but we like to think more broadly— that we’re likely to get something done by the end of the year, even if you’d like to know it’s going to be July or September or something like that.” This is an off-the-cuff response, but the “July or September” comment might hint at a higher probability of an earlier move than previously believed (although July is highly unlikely).
Q: What are the key things to watch?
A: The next key piece of information is the May FOMC minutes on May 24. We would expect the discussion of the funds rate outlook to be consistent with the March dot plot, based on the communications provided since the meeting. But the discussion of the balance sheet outlook could be more interesting, both from a timing perspective and with regard to any operational details of the upcoming transition.
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