What the FOMC Minutes Reveal about Normalization

The Federal Reserve released the minutes from its June policy-setting meeting yesterday afternoon. The Federal Open Market Committee (FOMC) minutes reflect an economic outlook consistent with recent public comments made by Fed officials: an improving labor market, confidence that the current path of monetary policy will achieve 2% inflation in the long run, and an expectation that economic growth will continue to rise from the disappointing Q1 figures.

Balance Sheet Reduction

The minutes note that all FOMC participants agreed to the balance sheet reduction program, which was described in more detail in an update to the Fed's Policy Normalization Principles and Plans following the June policy meeting. In sum, the program suggests that the Fed will limit the reinvestment of the principal of maturing assets on its balance sheet through a series of monthly caps. Initially, the Fed will allow up to $6 billion in Treasuries and $4 billion in agency debt and MBS to roll off each month. Whatever matures above those limits in a given month will continue to be reinvested. Every three months the caps will increase by $6 billion for Treasuries and $4 billion for agency debt and MBS over 12 months until $30 billion of Treasuries and $20 billion of agency debt and MBS are rolling off each month. The Committee anticipates these to be the monthly caps until the balance sheet returns to a new normal that is considerably lower than the present $4.5 trillion level but appreciably higher than its pre-crisis level of around $800 billion.

One new detail revealed in the minutes is that the FOMC seems to be split on when the balance sheet wind down should be announced. Some members want to announce the start date within a couple months while others prefer to wait until late this year. Noticeably absent from the minutes is a discussion about the actual start date for the reduction plan.

The Inflation Target

Another detail of interest is that one FOMC member suggested the Committee’s commitment to a 2% inflation target would be more publicly credible if the Fed allowed for a period of above 2% inflation. Since FOMC minutes don't name names, we can only speculate that this suggestion came from Neel Kashkari — the only voter to dissent at the meeting, preferring to have held rates steady in June. Many monetary policy analysts have recently suggested that the Fed’s inflation target is asymmetric, meaning that policymakers are much more comfortable undershooting the target than overshooting it.

Financial Stability

FOMC members expressed a range of views on matters related to financial stability. Some participants are concerned that the current labor market could lead to rapidly rising inflation and increased financial instability, a development that would call for aggressively raising the target range for the federal funds market. Others do not believe previous episodes of labor market inflation dynamics are relevant to today, and are therefore less concerned that low unemployment will cause inflation to increase excessively. Another member believes the financial system is more robust to shocks today than it was before the crisis, but also noted that the FOMC should remain “vigilant” about developments in financial markets.

Interest Rates

The Committee is divided on how the balance sheet reduction will impact the path of interest rates, with some members believing that as securities roll off the frequency of rate increases can slow. Others anticipate that normalizing the balance sheet will not materially affect the path of rate hikes.

Something of concern is that there is no mention of how the FOMC intends to normalize policy in the federal funds market. The minutes contain no discussion of how, when, or if the FOMC will end its policy of paying above market interest on excess reserves, a policy that prevents a traditional federal funds market from emerging.

Another area with a troubling lack of clarity is the Committee’s continued practice of citing a lower than normal neutral (or natural) rate of interest as justification for its policy stance without sharing its estimates of that neutral rate. If monetary policy is supposedly data driven, the Fed should be transparent about the data and estimates it is using.

Conclusion

Overall, as is typical, the minutes reveal little new. The path to normalization is starting to materialize, but with ample room for the Fed to reverse course. While the FOMC will likely announce when balance sheet reductions are to begin, that actual start date is still unclear with lots of flexibility for the Fed to backtrack on ending balance sheet reinvestments. And without a strategy for unwinding interest on excess reserves simultaneously, the path to normalization is fraught with challenges.

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