Fed Officials Split Over Next Rate Increase

By David HarrisonFeaturesDow Jones Newswires

Federal Reserve officials meeting in July split over the timing of future interest rate increases as they struggled to understand why inflation has been so weak in recent months. But they agreed to soon begin the years-long process of drawing down the central bank's holdings, according to minutes of the July 25-26 meeting released Wednesday after the customary three-week lag.

Sagging inflation led some officials to suggest holding off on raising rates again for now, arguing the Fed "could afford to be patient under current circumstances."

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Others, however, worried that the strong labor market and high stock prices could produce a spurt of inflation above the central bank's 2% target that could be difficult to control. This group cautioned that waiting too long to raise rates "could result in an overshooting of the [Fed's] inflation objective that would likely be costly to reverse," the minutes said.

The minutes could raise doubts about the prospects of another increase in the Fed's benchmark interest rate by year's end. The central bank has raised rates twice this year and penciled in a third rate increase in 2017 as well as three in 2018.

Fed officials have been publically airing their disagreement over the proper course of interest rates since the meeting.

On. Aug. 11, Dallas Fed President Robert Kaplan said he wants to see "more evidence" of progress towards the inflation goal before he'll support another rate increase, adding that the current 1% to 1.25% range for the Fed's benchmark short-term interest rate was "appropriate." He spoke a day after Chicago Fed President Charles Evans urged officials to "be very careful in assessing the future [rate] moves."

New York Fed President William Dudley, on the other hand, said in an interview with the Associated Press this week that he "would be in favor of doing another rate hike later this year."

The split has left markets questioning a third rate increase in 2017. As of Wednesday morning, before the release of the minutes, investors saw a roughly 50% probability the Fed would leave rates unchanged through year's end.

Fed Chairwoman Janet Yellen could have a chance to weigh in at the Kansas City Fed's annual economic conference in Jackson Hole, Wyo., later this month.

Fed officials and economists have struggled over the past few years to reconcile booming job growth with weak price pressures. Under standard economic theory, a better labor market would lead to higher wages and consumer prices. That hasn't happened.

Some officials in July said they thought the standard theory "was not particularly useful," while others believed it remained valid. Puzzled policy makers talked through possible explanations for the disconnect, including possible structural changes in the labor market or imprecise data, according to the minutes.

Ms. Yellen,in Congressional testimony last month, said she believed inflation would move back to 2% over the next couple of years.

Data released since the meeting, however, showed inflation continues to weaken while the labor market continues to strengthen. Prices rose 1.4% in June over the previous year, down from 1.5% in May, according to the Fed's preferred inflation gauge. Meanwhile, employers added a healthy 209,000 jobs in July and the unemployment rate ticked down to 4.3%, matching the lowest level in 16 years.

The minutes also indicated that officials were confident their plans to slowly reduce their $4.5 trillion portfolio would run smoothly without disrupting markets. Some officials were ready to announce the start of the portfolio runoff in July but "most preferred to defer that decision until an upcoming meeting" in order to gather more information, the minutes said. Offcicials agreed that they should begin the process "relatively soon."

The Fed next meets on September 19-20. In recent weeks, some Fed officials have said the September meeting would be an appropriate time to begin shrinking the balance sheet.

In the aftermath of the financial crisis, the Fed launched large-scale asset purchase programs that scooped up Treasury and mortgage-backed securities to lower long-term borrowing costs. Today, with the economy on a firmer footing, officials are ready to start unwinding those programs by letting a preset amount of securities mature every month. Officials haven't said when they'll begin or how much they are likely to shrink their portfolio.

Policy makers at the July meeting said they expected market reaction to the portfolio reduction process to be muted. Unwinding the asset purchase programs would "contribute only modestly" to tighter monetary policy, they said.

Economists at Goldman Sachs estimate shrinking the balance sheet will raise 10-year Treasury yields by 0.2 percentage point this year, 0.15 percentage point next year and 0.1 percentage point between 2019 and 2012.

Yields have been historically low in recent years, hovering below 2.3% for the past two weeks.

The July minutes also said that some Fed officials see a waning possibility that the Republican-held Congress and the Trump administration will manage to push through their ambitious plans for a tax overhaul and new infrastructure spending.

(END) Dow Jones Newswires

August 16, 2017 14:15 ET (18:15 GMT)