A window into the views of the U.S. Federal Open Market Committee is offered by the minutes of its March 18-19 meeting. The minutes, released on April 9, tell me that the Federal Reserve has a balanced view of the U.S. economy. This is in contrast to the manic-depressive behaviour of the financial markets, which are driven by headlines and snippets taken out of context.
Here is my take from the meeting minutes.
The slowdown in the economy is not just due to the cold weather
The committee has seen improvements in terms of an increase in economic activity and rising employment. However, it is also aware that the initial slowdown was not only due to extreme cold weather, as reported by many economists in the first quarter of 2014. In addition, our assessment of economic data agrees with the Fed’s view: we see a moderation in U.S. growth.
In addition, the Fed sees a slowdown in the housing and construction sector due to the rise in mortgage rates and the end of institutional money being used to purchase cheap rental assets. It has lowered its growth forecasts with risks slightly tilted to the downside, especially in the environment of zero interest rates.
There is not enough wage growth
The recent rise in hourly earnings is not enough to lift real wages, the Fed believes. The increase in earnings was behind a slew of economists’ forecasts for rate hikes earlier than what is priced into the bond market. The March employment report took year-over-year hourly earnings back to 2.1% nominal growth, which has persisted in recent months. This is not enough in the Fed’s eyes.
Credit growth is limited
Consumer credit growth outside of auto and student loans is limited. The Fed would like to see more organic credit demand in credit cards, mortgages, etc.
Jeremy Stein, a former member of the Board of Governors of the Fed, was concerned about the narrowing of credit spreads to bubble territory. He was vocal about the consequences of ultra-accommodative monetary policy over a long period of time. It almost seems as if the committee was not particularly interested in this topic. In regards to financial stability, the committee has discussed equity market margin debt and the return of sub-prime lending.
The committee continues to forecast below-target inflation for the next few years, but are comforted by stable inflation expectations. There was an extended discussion on inflation and concerns if inflation does not increase. The committee pointed to temporary factors (e.g. medical services) that may be keeping inflation down but the committee members are hoping that inflation returns to the target rate as the economy recovers.
We believe the lack of inflation is a sign of slack in the labour market and weak final demand. It shows that corporations and producers do not have pricing power. Disinflation is not limited to the U.S. and is occurring in all advanced economies excluding Japan. The weakness in inflation is not caused by one-off factors.
Unemployment rate does not correctly reflect the amount of slack
The committee discussed the level of slack in the economy and how the falling unemployment rate may not correctly reflect the amount of slack in the labour market. The Fed is still debating whether unemployment in the U.S. is cyclical or structural. In our view, the depressed level of wage growth is a sign that the excess capacity in the economy is still large.
The Fed believes the tapering of quantitative easing is not tightening
The Fed agreed to reduce the size of its purchases of long-term bonds and mortgages by $10 billion a month. The committee believes that since the balance sheet is still growing, tapering is not tightening.
I disagree with this assessment. Since the announcement of tapering last May, there has been substantial tightening in terms of increased long-term real rates. Higher mortgage rates have led to reduced housing activity. This is a clear indicator that tapering is tightening.
The terminal neutral Fed Fund’s rate will be lower after rate normalization
The committee is contemplating ways to telegraph to the market that the terminal neutral Fed Fund’s rate would probably be lower than previous cycles. Some reasons that were discussed include
- higher savings by the household sector after the bust in the housing market
- higher global levels of savings
- aging population
- slower potential output as a result of permanent loss of productivity
- restraint on the availability of credit
This topic has been discussed by central banks in the U.S., Canada, England, Australia, and Europe. The debate on the lower neutral rate began when Larry Summers, a former President of Harvard University, suggested that the neutral real rate may have turned negative permanently.