Fed Minutes May Show Battle Lines Hardening Over Soft Inflation

  • Economists watching for signs of wavering commitment to hikes
  • FOMC likely on track for September balance-sheet announcement

Mike Ryan, chief investment officer at UBS Wealth Management Americas, talks about the impact of U.S. economic data and inflation on the Federal Reserve's rate path. He speaks on 'Bloomberg Daybreak: Americas.' (Source: Bloomberg)

Federal Reserve watchers may get a better feel Wednesday for how many policy makers remain resolved to raise interest rates again this year, and how many are wavering amid a five-month stretch of soft inflation reports.

Economists and investors are also keen for more details about when the central bank will begin to run down its $4.5 trillion balance sheet when the Fed releases minutes of the Federal Open Market Committee’s July 25-26 meeting at 2 p.m. in Washington. Analysts expect the start of a gradual unwind of the balance sheet to be announced in September, with the next rate hike delayed until the final month of the year.

“The most likely market-moving discussion will be around inflation,” said Michael Hanson, chief U.S. macro strategist at TD Securities in New York and a former Fed economist. “It will be interesting to see whether there’s a little more ground given in the middle of the committee” acknowledging worries over low inflation.

Fed officials have indicated they are on course to raise their benchmark lending rate by a quarter percentage point one more time this year, following hikes in March and June. They’ve also signaled they intend to begin trimming the balance sheet “relatively soon,” a move that is also expected to raise the cost of credit to households and businesses, but less significantly than a rate increase.

Strong job gains bolster the argument of those on the committee who want to tighten policy to head off any eventual spike in inflation. But falling unemployment -- 4.3 percent in July -- has yet to trigger wage gains that might feed overall price rises. The Fed’s preferred gauge of inflation slowed to 1.4 percent in June, well below the central bank’s 2 percent target.

Many officials, including Chair Janet Yellen, have pinned the weak inflation reports mostly on “transitory” and “idiosyncratic” price drops in specific sectors such as mobile phone services and pharmaceuticals. Yellen, however, conceded in testimony before Congress on July 12 that “there could be more going on.”

“I would be surprised if committee members continuing to think that transitory one-offs” explain the weakness in inflation, Hanson said. “We could see a discussion suggesting broader concern that inflation may run meaningfully below target for longer.”

Stephen Stanley, chief economist at Amherst Pierpont Securities in New York, agreed the division in the committee over inflation will likely widen, with each additional month of weak price rises pushing the debate in favor of the doves. Still, don’t expect any decisive shift in opinions, he added.

“The good news from the Fed’s perspective is they’ve lined this up so that they don’t have to make a decision until December,” Stanley said. “It still can be a relatively vague conversation.”

Otherwise, Stanley said he’ll be watching for confirmation that the FOMC will announce the timing for its balance-sheet reduction plan after their meeting scheduled for Sept. 19-20.

“I think they’ll make it more explicit that the default scenario is for an announcement in September,” he said.

If the Fed follows the pattern set previously when it changed the amounts of monthly asset purchases, Hanson said a September announcement would put the Fed on track to begin rolling securities off the balance sheet on Oct. 1.

The Fed accumulated its unprecedented portfolio of Treasury and mortgage-backed securities in during and after the financial crisis in an effort to suppress longer-term borrowing rates and stimulate the U.S. economy after already having lowered overnight rates to zero.

The minutes might also show that moving ahead on the balance sheet will, for the time being, take some of the tension out of the Fed’s debate over inflation. That’s partly because hawks and doves appear to have different expectations for the impact on financial conditions of trimming the balance sheet, said Drew Matus, chief market strategist at MetLife Investment Management in Whippany, New Jersey.

“Everyone’s OK with moving on the balance sheet,” Matus said. “The hawks think that will reduce the risk of inflation, while those worried that inflation is too low aren’t worried about the impact of the balance sheet.”

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