It was not a surprise that the FOMC described the amount of under-utilization in the labor market as “gradually falling”. Nonetheless, the Minutes were on the hawkish side for two main reasons.
First, the comments played down the importance of dollar strength and recent growth disappointments outside the U.S. True, cheaper oil will provide an important offset to a more expensive currency in terms of economic growth, but it still seems complacent to downplay the impact of sluggish global demand on the U.S.
Second, the FOMC downplayed the plunge in long-term inflation expectations. Lower food and energy prices will of course depress headline inflation in the near term, but even forward measures of inflation expectations based on the CPI swaps market have fallen below levels that preceded QE2, QE3 and Operation Twist. Policymakers suggested that the shift could reflect a diminution in the inflation risk premium, rather than in inflation expectations themselves.
Nonetheless, the drop in forward inflation expectations has occurred against the backdrop of weakening commodity prices, dollar strength and downward revisions to global growth. It seems a stretch to argue that long-term inflation expectations were unaffected by this backdrop. Indeed, the University of Michigan consumer inflation expectations measure fell in November, which means that survey-based measures may not be as stable as the FOMC thinks. Even the Fed Staff project that actual inflation will remain below target for “the next few years”.
The Minutes revealed that FOMC will at least be “attentive” to evidence of a possible downward shift in longer-term inflation expectations because it “…would be even more worrisome if growth faltered.” This suggests that the Fed will be quick to lower the “dot plot” in the event of any growth disappointments.
Bottom Line: The FOMC has a greater tolerance for falling inflation expectations than we previously thought. The Minutes have given a green light to further dollar strength and modestly lower Treasury bond prices in the near term. These trends seem likely to continue until either growth disappoints, the equity market buckles or measures of long-term inflation expectations become intolerably low for policymakers.