The minutes of the Federal Open Market Committee’s (FOMC) last meeting of 2017 highlighted the strong and strengthening pace of economic expansion despite hurricane-related distortions.
Many participants anticipated that the announced changes to business taxes would provide a "modest boost to capital spending, although the magnitude of the effects was uncertain". However, supply-side effects were deemed somewhat uncertain, citing industry contacts that tax savings were likely to be used for mergers and acquisitions rather than for capital expenditures.
The prospect of personal income tax cuts led many participants to expect "some boost to consumer spending", with a few noting that the expectation of a tax cut has likely already acted to boost asset prices, and thus household net worth. Similarly, personal tax cuts were viewed by a few participants to help boost labor supply by an uncertain amount.
A strengthening labor market outlook helped drive a debate on wages and inflation. Although wage growth has been largely viewed as modest, a few participants anticipated an acceleration in wage growth as labor markets tightened further. Furthermore, many participants expected the tightening labor market to result in inflation in the medium term, but some participants continued to fret about core inflation persisting below 2% target. On that note, several participants were concerned with inflation expectations falling further.
The flattening of the yield curve was discussed, with participants citing fed rate hikes, lower market estimates of the longer-run neutral real interest rate, lower inflation expectations, and lower term premiums as the main drivers. Interestingly, they generally agreed that "the current degree of flatness of the yield curve was not unusual by historical standards". But, the slope of the yield curve will likely continue to be monitored since historically an inversion of the yield curve has been a predictor of an economic slowdown.
Lastly, participants discussed the timing and the size of future adjustments of Fed policy, with most participants reiterating their support for a gradual increase in the target range. However, they discussed several risks that could result in a steeper path of rate hikes. One such risk was an unwarranted build-up in inflation if the economy was expanding "well beyond its maximum sustainable level", possibly due to fiscal or excess monetary stimulus. Similarly, risks that could result in a flatter yield curve were also discussed, including a risk that inflation could fail to move to the 2% target. On net, participants viewed the risks as "roughly balanced", and they will continue to monitor inflation developments closely.
Key Implications
Above-trend economic growth is likely to continue into the first half of 2018, suggesting that the FOMC could raise interest rates at its upcoming meetings in January or March. Moreover, the expected boost to economic growth from tax cuts helps to build a strong case for an additional two rate hikes before the end of this year, in line with the three rate hikes communicated in the FOMC’s Summary of Economic Projections (SEP) last month.
The debate concerning the evolution of inflation continues at the Fed, ensuring that normalization will remain a gradual process. If inflation fails to make material progress in 2018 the Fed will likely only raise interest rates twice.
With four Federal Reserve board of governor seats still up for grabs, President Trump’s administration has the ability to alter the composition of the Federal Reserve and the future course of monetary policy to align it better with its goals. As such, the nomination process will continue to be carefully watched by investors for any indications of a change in the pace of monetary policy normalization.
