FOMC Balance Sheet Normalization Coming “Relatively Soon”

In a statement following its two-day meeting covering July 25 and 26, the Federal Open Market Committee (FOMC or the Committee) decided to “maintain the target range for the federal funds rate at 1 to 1.25 percent”. All FOMC members voted in favor of this decision. In its statement, the FOMC maintains that, at this level, “the stance of monetary policy remains accommodative”.

As the statement says, “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.” Overall, the evidence suggests that the labor market continues to “strengthen”. Over 2017, additions to payroll employment have averaged about 180,000 per month. Since the FOMC met in June, payroll employment rose by 222,000 over the month of June, with the Bureau of Labor Statistics also reporting upward revisions to the number of jobs added in both April and May. At the same time, the unemployment rate currently sits at 4.4 percent.

However, the FOMC also noted its concerns about inflation, or price stability. The FOMC explicitly targets a 2.0 percent annual growth rate in the price level. As shown in the June 14, 2017 FOMC Projections materials, the FOMC tracks PCE and core PCE inflation instead of the CPI. In addition, a recent speech by Governor Lael Brainard, a member of the Federal Reserve Board of Governors and a voting member of the FOMC, notes that the FOMC’s preferred measure of inflation is “the headline measure of consumer price inflation on a national accounts basis”, although she tends “to place greater weight on the core measure of inflation, which abstracts from the transitory movements in energy prices and is a better predictor of future inflation.”

In recent months, measures of inflation are below the 2.0 percent level. The concern over low inflation currently is, in part, reflected in its divergence from some generally used economic frameworks employed to understand it. For example, using the Phillips Curve, which relates the unemployment rate with inflation, the current unemployment rate would suggest that inflation should be closer to the FOMC’s target. This is because the Phillips Curve describes a historical inverse relationship between rates of unemployment and corresponding rates of inflation.

The relationship described by the Phillips Curve might manifest if a tight labor market, as symbolized by a low unemployment rate, led to higher wage growth. As Governor Brainard notes, “The Atlanta Fed’s Wage Growth Tracker tells a similar story: Upward movement in wage gains was observed until about a year or so ago, but there has been little acceleration recently.” Additional analysis by the NAHB has shown the role that housing, via shelter costs faced by urban consumers, plays in changes in the CPI. However, the Shelter component of PCE inflation is likely smaller than its weight in the CPI.

The data indicate that current inflation is below its target because expectations about inflation remain below 2.0 percent. As the July FOMC statement notes “Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.” Rational Expectations Theory implies that expectations of price changes are equal to prices changes in the present, absent any shocks, such as energy price volatility. The connection between expectations of and current inflation might be established if consumers demanded raises in anticipation of their costs rising in the future and obtained the raises. A previous NAHB post highlighted the recent slowdown in inflation and in the market-based measure of inflation expectations, demonstrating its ramifications for mortgage rates.

In the same speech, Gov. Brainard provides one suggestion as to why returning to 2.0 percent inflation is important. “Attaining the Committee’s symmetric target for inflation on a sustainable basis is especially important in the current environment, with the neutral real interest rate at historically lower levels, in order to ensure conventional policy has room to respond to unexpected adverse developments.”

Finally, as part of the material released followings its June meeting, the FOMC affirmed “that changing the target range for the federal funds rate is its primary means of adjusting the stance of monetary policy.” However, the FOMC also plans to shrink its balance sheet as well. A previous NAHB post described the changes the FOMC plans to take in order to shrink its balance sheet. Although, no date has been set, “the Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.”

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