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Take-Aways from the Fed's Minutes: Increase in Uncertainty

In Short

Higher uncertainty means that the Fed will take a wait-and-see course before adjusting policy further. It may be the case that the market already has done the Fed’s work (i.e., tightening financial conditions) for them via 1) declines in equity prices, 2) wider credit spreads 3) a further rise in the exchange value of the dollar and 4) increased financial market volatility. The four policy tightenings for 2016 that the Fed had indicated in their year-end forecast are looking increasing unlikely.

On Future Policy:

“Most participants indicated that it was difficult to judge at this point whether the outlook for inflation and economic growth had changed materially, but they thought that uncertainty surrounding the outlook had increased as a result of recent financial and economic developments. Most participants were of the view that there was not yet enough evidence to indicate whether the balance of risks to the medium-term outlook had changed materially, but others judged that recent developments had increased the level of downside risks or that the risks were no longer balanced. Several participants noted that monetary policy was less well positioned to respond effectively to shocks that reduce inflation or real activity than to upside shocks, and that waiting for additional information regarding the underlying strength of economic activity and prospects for inflation before taking the next step to reduce policy accommodation would be prudent. While participants continued to expect that gradual adjustments in the stance of monetary policy would be appropriate, they emphasized that the timing and pace of adjustments will depend on future economic and financial market developments and their implications for the medium-term economic outlook. A couple of participants questioned whether some financial market participants fully appreciated that monetary policy is data dependent, and a number of participants emphasized the importance of continuing to communicate this aspect of monetary policy.”

“Participants agreed that incoming indicators regarding labor market developments had been encouraging, but also that data releases since the December meeting on spending and production had been disappointing. Furthermore, developments in commodity and financial markets as well as the possibility of a significant weakening of some foreign economies had the potential to further restrain domestic economic activity, partly because the large cumulative declines in energy and other commodity prices could have pronounced adverse effects on some firms and countries that are important producers of such commodities. However, a few noted that the potential positive effects of lower energy costs on economic activity were a mitigating factor. Participants judged that the overall implication of these developments for the outlook for domestic economic activity was unclear, but they agreed that uncertainty had increased, and many saw these developments as increasing the downside risks to the outlook.

On Financial Conditions/CRE:

“Almost all participants cited a number of recent events as indicative of tighter financial conditions in the United States; these events included declines in equity prices, a widening in credit spreads, a further rise in the exchange value of the dollar, and an increase in financial market volatility. Some participants also pointed to significantly tighter financing conditions for speculative-grade firms and small businesses, and to reports of tighter standards at banks for C&I and CRE loans. The effects of these financial developments, if they were to persist, may be roughly equivalent to those from further firming in monetary policy. Participants mentioned several apparent factors underlying the recent financial market turbulence, including economic and financial developments in China and other foreign countries, spillovers in financial markets from stresses at firms and in countries that are producers of energy and other commodities, and an increase in concerns among market participants regarding the prospects for domestic economic growth. However, a number of participants noted that the large magnitude of changes in domestic financial market conditions was difficult to reconcile with incoming information on U.S. economic developments. A couple of participants pointed out that the recent decline in equity prices could be viewed as bringing equity valuations more in line with historical norms. Additionally, a few participants cautioned that valuations in CRE markets should be closely monitored. The effects of a relatively flat yield curve and low interest rates in reducing banks’ net interest margins were also noted.”

Many members judg[ed] that uncertainty had increased. Members generally agreed that the implications of the available information were not sufficiently clear to allow members to assess the balance of risks to the economic outlook in the Committee’s post-meeting statement. However, members observed that if the recent tightening of global financial conditions was sustained, it could be a factor amplifying downside risks.”

On Inflation:

Most continued to anticipate that once the price of energy and the exchange value of the dollar stabilized, the effects of those factors on inflation would fade. Several saw that outlook as depending importantly on continued strengthening of the labor market or on an above-trend pace of economic activity. Moreover, some emphasized the need for longer-run inflation expectations to remain well anchored. In that regard, while some participants interpreted the recent readings on survey-based measures of inflation expectations and market-based measures of inflation compensation as suggesting that long-term inflation expectations were still relatively well anchored, some others expressed concern about the further decline in inflation compensation recently and the historically low levels of some survey measures of longer-run inflation expectations. Some noted the difficulty of distinguishing declines in expected inflation embedded in those market-based measures from changes in risk and liquidity premiums or of interpreting the current high correlation of far-forward measures of inflation compensation and oil prices. Although most participants continued to expect that inflation would rise to the Committee’s 2 percent objective over the medium term, a number of participants indicated that, in light of recent developments, they viewed the outlook for inflation as somewhat more uncertain or saw the risks as being to the downside. Several participants reiterated the importance of monitoring inflation developments closely to confirm that inflation was evolving along the path anticipated by the Committee.”

“Most participants still expected inflation to increase gradually once energy prices and the prices of non-energy imports stabilized and as the labor market strengthened further. However, a few participants noted that direct evidence that inflation was rising toward 2 percent would be an important element of their assessment of the outlook and of the appropriate path for policy.”

On Jobs:

“Many viewed labor market underutilization as having been substantially reduced over the past year, and a few saw slack as having been largely eliminated. In their comments on labor market conditions, participants cited strong employment gains, low levels of unemployment in their Districts, reports of shortages of workers in various industries, or firming in wage increases. Most anticipated that employment would expand at a solid rate over the year ahead, although several saw the prospect of some moderation in employment gains from the particularly large increases in the fourth quarter of 2015.”

On International Volatility:

“In assessing the medium-term outlook, participants discussed the extent to which the recent turbulence in global financial markets might restrain U.S. economic activity. While acknowledging the possible adverse effects of the tightening of financial conditions that had occurred, most policymakers thought that the extent to which tighter conditions would persist and what that might imply for the outlook were unclear, and they therefore judged that it was premature to alter appreciably their assessment of the medium-term economic outlook… Given their increased uncertainty about how global economic and financial developments might evolve, participants emphasized the importance of closely monitoring these developments and of assessing their implications for the labor market and infla-tion, and for the balance of risks to the outlook.”

“Regarding the foreign economic outlook, it was noted that the slowdown in China’s industrial sector and the decline in global commodity prices could restrain economic activity in the EMEs and other commodity-producing countries for some time. Participants discussed recent developments in China, including the possibility that structural changes and financial imbalances in the Chinese economy might lead to a sharper deceleration in economic growth in that country than was generally anticipated. Such a downshift, if it occurred, could increase the economic and financial stresses on other EMEs and on commodity producers, including Canada and Mexico. Moreover, global financial markets could continue to be affected by uncertainty about China’s exchange rate regime. While the exposure of the United States to the Chinese economy through direct trade ties was limited, a number of participants were concerned about the potential drag on the U.S. economy from the broader effects of a greater-than-expected slowdown in China and other EMEs.”

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Heidi Learner

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