Growing divide among Fed officials highlights economy’s odd state

As expected the Fed opted to raise the federal funds rate 25 basis points at the Wednesday meeting to a range of 1.25 percent to 1.50 percent. The third-round hike in 2017, overall this is the fifth-rate increase since liftoff in December 2015.   

Priced in at near 100 percent certainty prior to the announcement, according to Bloomberg, perhaps more notable than the rise in rates is the upcoming change in leadership.

{mosads}The press conference was Janet Yellen’s final appearance as Fed chairwoman before she hands over the reins to Jerome Powell, whose nomination was confirmed on Dec. 5. Yellen leaves a strong legacy at the Fed of supporting the economy through a stagnant recovery.

According to the December Federal Open Markets Committee (FOMC) statement, the Fed sees the economy on “solid” footing amid continued strengthening in the labor market and a further expansion of household spending. Furthermore, hurricane disruptions were noted to have not “materially altered” the outlook for the national economy.

On the inflation front, the Fed acknowledged that both overall inflation and inflation for other items excluding food and energy, as well as inflation expectations, remain low. Despite running shy of the committee’s 2-percent target, however, members are somewhat confident that prices will continue to move toward the Fed’s longer-run objective over the near-to-medium term.

Following Wednesday’s weaker-than-expected inflation report, however, showing an unexpected decline in the core Consumer Price Index (CPI) to a 1.7-percent annual pace, at least some on the Fed are no doubt questioning the “transitory” nature of low inflation.

While certainly not enough to dissuade the Fed from taking additional steps to remove accommodation at Wednesday’s meeting, the still-soft inflation data does call into question the committee’s pathway for additional policy removal in the new year.

Several Fed members, including the incoming Chair Jerome Powell, have suggested a need of further evidence of rising inflation before moving ahead with additional policy adjustments after today’s meeting.

Both Chicago Fed President Charles L. Evans and Minneapolis Fed President Neel Kashkari voted against today’s policy decision in favor of maintaining the existing target range for the federal funds rate. In addition, there was no mention of balance sheet normalization.

According to the latest Summary of Economic Projections, the majority of Fed officials expect the U.S. economy to remain on a positive trajectory, raising the 2017 and 2018 GDP forecasts to 2.5 percent from 2.4 percent and 2.1 percent, respectively, but maintaining a more moderate longer-run expectation of 1.8 percent.

The committee’s inflation forecast, furthermore, was little changed: Expectations for 2017 headline inflation rose one-tenth of a percentage point from 1.6 percent to 1.7 percent. The committee’s 2018 headline inflation forecast was unchanged at 1.9 percent.

Additionally, the Fed’s projections for core inflation held steady at 1.5 percent and 1.9 percent in 2017 and 2018, respectively, unchanged from September’s projections. 

Finally, despite more positive rhetoric surrounding the health of the U.S. economy at present, the Fed maintained its outlook for three additional rate hikes in the coming year. Many analysts on Wall Street has projected an increase to four or more potential rate hikes next year.

However, even at three, with inflation stubbornly low and the new Fed leader less willing to adjust rates in anticipation of further inflation, the committee’s latest projections may be over-promising additional monetary action come 2018.

Accompanying the Fed’s December forecast was an updated version of the dot plot — the targets for appropriate federal funds rates by FOMC participants. Looking at the dispersion of the dots within the dot plot, it’s clear there is a widening divide between the more hawkish members and the more dovish members.

The hawks still expect stronger inflation after years of missing the Fed’s 2-percent target, and they forecast upwards of five rate hikes next year. The doves have been increasingly skeptical of the “transitory” pressure argument holding prices artificially low, and at least one member forecasted a rate cut by the end of 2018.

The growing divide between Fed officials highlights the ongoing conundrum of stable growth and continued improvement in the labor market with low inflation, leaving monetary policy at the whim of Fed officials and their choice of which component of their dual mandate takes precedence: stable prices or full employment.

The bottom line is, as expected, the Fed opted to raise rates amid a recent slew of more positive data suggesting a continued “solid” pace of growth. Going forward, however, with inflation still low, additional rate hikes in 2018 may prove fewer than expected.

In other words, the Fed has little reason to deviate from a slow and gradual pathway to higher rates in the coming months. In fact, 2018 is likely to be a year of slower and lower beyond what many anticipate.

Lindsey Piegza, Ph.D., is the chief economist for Stifel Fixed Income. She has had her research published in Harvard Business Review and in textbooks for Northwestern University’s Kellogg Graduate School of Management. She’s a regular guest on CNBC, Bloomberg, Fox News and CNN.