Review of FOMC Minutes

January 4, 2017

Minutes of the Federal Open Market Committee’s December meeting that hiked the federal funds range target by 25 basis points to 0.50 – 0.75% paid only scant attention the disinflationary risk of dollar appreciation:

Several, participants, however, pointed out that market-based measures of inflation compensation were still low or that downside risks to inflation remained, given the recent further appreciation of the dollar.

The U.S. currency rallied strongly in the wake of the November election and is even stronger now than when the FOMC announced its decision on December 14. A composite dollar index measured against a basket of other major currencies touched its strongest level since December 2002 earlier this week. A stronger dollar depresses the prices of imports and import-competing goods.

Instead of dwelling on the dollar and other downside price factors, the minutes instead paid most attention to upside risks to inflation and things that might tighten the labor market more than assumed. More importantly, the minutes make clear that the path of future increases in the federal funds rate is more likely to deviate to the upside from the baseline “gradual” upward path.

Many participants judged that the risk of a sizable undershooting of the longer-run normal unemployment rate had increased somewhat and that the Committee might need to raise the federal funds rate more quickly than currently anticipated to limit the degree of undershooting and stem a potential buildup of inflationary pressures. However, with inflation still below the Committee’s 2 percent objective, it was noted that downside risks to inflation remained and that a moderate undershooting of the longer-run normal unemployment rate could help return inflation to 2 percent. A couple of participants expressed concern that the Committee’s communications about a gradual pace of policy firming might be misunderstood as a commitment to only one or two rate hikes per year; participants agreed that policy would need to respond appropriately to the evolving outlook. Several participants noted circumstances that might warrant changes to the path for the federal funds rate could also have implications for the reinvestment of proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities.

Several members noted that if the labor market appeared to be tightening significantly more than expected, it might become necessary to adjust the Committee’s communications about the expected path of the federal funds rate, consistent with the possibility that a less gradual pace of increases could become appropriate.

Taken alone, the minutes back up the newly enhanced pro-dollar psychology in global foreign exchange markets, but investors need to bear in mind that the Trump administration will show only so much tolerance for an ever-strengthening dollar that could undermine the President-Elect’s desire to eliminate a U.S. trade deficit. As a campaigner and president-elect, he hasn’t shied away from from using the bully-pulpit, and many former presidents have used verbal cues very effectively to achieve desired movement in the dollar. A comparatively recent example was Bill Clinton, whose first Treasury Secretary, Lloyd Bentsen, managed to lift the yen quite extensively during the first half of 1993 with complaints about its level, the size of Japan’s trade surplus, and perceived unfair Japanese protectionist practices. From Trump’s perspective, China, Germany, Mexico and even Japan still would head a list of usual suspects in a possible verbal assault such as that waged in 1993.

Another thought to bear in mind is that the Fed merely needs to tighten monetary conditions. Raising short term interest rates is one way. But an appreciating dollar and rising long-term rates also meet the goal. If monetary officials had a choice, it would be better to raise interest rates than see the dollar increase because a higher federal funds rate is needed to create response maneuverability to the next U.S. recession. Today’s minutes in fact assign greater downside than upside risk to its baseline growth projection simply because rates can be easily raised more quickly if the economy runs too hot but not cut with the same ease if the economy stalls.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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