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FOMC Minutes Preview: Reasons To Be Fearful?

The FOMC surprised the market on March 18 by lowering "the dots" by about 50 basis points. While Yellen gave a fairly exhaustive explanation for this in her speech on March 27 (and Dudley just managed expectations this morning), SocGen notes that market participants hope for more color from the FOMC minutes today. As for the timing of the rates lift-off, the FOMC minutes are unlikely to offer any new insight.

 

Via SocGen, FOMC minutes – looking for reasons for lower “dots”

Despite removing the reference to “patience” from its rate guidance, the FOMC projected a very dovish message on March 18. Specifically, it surprised the market by lowering the entire rate trajectory (i.e. the “dots”) by about 50 basis points, suggesting a much gentler rate path than previously envisioned. Following the meeting, we were left unsatisfied by the explanations given for this revision. During the press conference, Yellen gave partial reasoning behind it, pointing to a lower assessment of NAIRU which was revised from 5.2-5.5% to 5.0-5.2%. However, this was not a sufficient explanation in our view since the Committee also revised its forecast for unemployment by roughly the same amount, suggesting no change in the outlook for labor market slack. The medium-term forecast for unemployment rate also did not change, which led us to believe that the Fed had suddenly relaxed its reaction function for unexplained reasons.

While we hope for more color from the FOMC minutes, Yellen gave a fairly exhaustive explanation for this in her speech on March 27. In it, she highlighted three special considerations that may bear on the pace of tightening in addition to data dependency; all three suggest a slower-than normal tightening cycle.

The first is a risk that the equilibrium real interest rate (RIR) – currently estimated near zero but eventually expected to rise to 1.75% - may not normalize as quickly as expected.

 

The second is the asymmetry in the effectiveness of monetary policy given the zero-bound.

 

The third is a desire to undershoot NAIRU for some time in an attempt to reverse some of the adverse supply-side developments resulting from the financial crisis, effectively buying insurance against a secular stagnation scenario.

For all these reasons, the Fed has decided that a gentler path is more appropriate. The dots suggest that this new view has broad support within the FOMC, but it will nonetheless be interesting to see the minutes for any new insight.

As for the timing of the lift-off, Yellen’s speech was also revealing in its clarity about the conditions for lift-off in rates; the FOMC minutes are unlikely to offer any new insight on this issue. She indicated that further improvement in the labor market would be the most important factor giving her “reasonable confidence” that inflation will return to 2 percent over the medium term. Importantly, a pickup in wage growth or inflation is not a necessary condition for hiking rates, although Yellen would be uncomfortable raising rates if underlying inflation pressures were to weaken. Of course, for the improvement in the labor market to continue, we need to see activity data consistent with above-trend growth and that is the missing element at the moment. We expect activity data to improve significantly during March-May, making the June meeting a strong contender for a lift-off in rates.