Federal Reserve officials debated whether new tax cuts approved by Congress would require them to raise short-term interest rates faster this year, after lifting them three times last year.
Officials expressed growing confidence in the strength of the labor market and the economy more broadly, according to minutes of the Fed's December policy meeting, which were released Wednesday. Since the meeting, Congress approved and President Donald Trump signed into law a $1.5 trillion tax cut, which could further muddy the Fed's efforts to ensure the economy remains on an even keel.
"Participants discussed several risks that, if realized, could necessitate a steeper path of increases" in the benchmark federal-funds rate, according to the minutes. "These risks included the possibility that inflation pressures could build unduly...perhaps owing to fiscal stimulus or accommodative financial-market conditions," the minutes said.
After holding its benchmark short-term rate near zero for seven years, the Fed has raised it five times since late 2015, most recently in December, to a range between 1.25% and 1.5%. Officials also penciled in three more quarter-percentage point rate increases in 2018 and two in 2019.
The Fed isn't expected to take any action at its next meeting, Jan. 30-31. Before the minutes were released, the market for federal-funds futures contracts, where traders bet on the path of interest rates, showed a 62% probability of a rate increase at the Fed's second meeting of the year, in March.
Even before Congress approved the tax cut, the Fed's internal debate over the future policy path has been complicated by two puzzles. Inflation moved further below the Fed's 2% target last year, justifying some officials' call for a slower pace of rate increases. At the meeting, officials highlighted the risk that interest rates would rise less quickly than anticipated if inflation continued to undershoot the central bank's forecast, and two officials voted against raising rates because they wanted to see more concrete evidence that inflation is rising after consistently running below the 2% target.
But the unemployment rate dropped lower than officials expected last year, to 4.1% in November. Many officials at last month's meeting said they expected pressures from sustained hiring to eventually raise wages and prices over the medium term. In addition, financial conditions have eased even though the Fed delivered three rate increases last year in addition to slowly paring its $4.5 trillion portfolio of bonds and other assets.
Employers added 170,000 jobs per month on average for the three months ended November, above the level economists expect is needed to provide jobs for new workforce entrants. The Labor Department will report on December's employment gains on Friday.
According to the Fed's preferred inflation gauge, consumer prices rose 1.8% in November from a year earlier, up from a 1.4% gain over the 12 months that ended in August. The acceleration partly reflected higher energy prices. Excluding food and energy, prices rose 1.5% on the year ended November, versus 1.3% in August.
The unemployment rate's continued decline "would perhaps push in the direction of slightly tighter monetary policy," said Fed Chairwoman Janet Yellen said at a press conference last month. A counterbalancing force, she said, is low inflation. "It could take a longer period of a very strong labor market in order to achieve the inflation objective," she added.
New fiscal stimulus adds yet another dimension to the Fed's efforts to keep the economy on a steady footing. At the December meeting, officials nudged their economic-growth estimates higher for the next few years on the expectation that congressional Republicans would pass tax cuts, which they did. Mr. Trump signed them into law about a week after the Fed meeting concluded.
Still, Fed policy makers' new projections suggested the boost from tax cuts wouldn't be so large they would have to speed up the pace of rate increase to guard against too much inflation. "Importantly, you really don't at the end of the day see very much change" in the path of rates, Ms. Yellen said at the press conference.
The minutes show officials expected the tax changes to boost consumer spending, though the magnitude of any boost remained uncertain. Likewise, officials saw a potential boost to capital spending.
An upturn in business investment could increase the economy's potential growth rate by raising its capacity to produce more goods and services, a development Fed officials would likely welcome because it would allow the economy to grow faster without spurring excessive inflation. But the minutes also show officials weren't sure how likely it was that the tax changes would induce businesses to invset more and whether companies might instead use higher after-tax profits to reduce debt, buy back stock or acquire other companies. Some business contacts and surveys show "firms were cautious about expanding capital spending in response to the proposed tax changes," the minutes said.
All of this makes the inflation question the most important one facing the Fed this year. If weak price pressures continue to defy the Fed's forecast of returning to 2% over the medium-term, the Fed can continue to raise rates very slowly. But if inflation picks up, that could prompt officials to lift them more aggressively.
Financial conditions could serve as another key barometer. Stock markets have advanced to new highs and long-term bond yields edged lower last year, giving support to those who supported raising rates despite the lack of clear signs of price pressure.
The minutes also show officials discussed the recent flattening of the yield curve, or the gap between short-term and long-term yields on government debt. In recent decades, when the yield curve inverts, so that short-term yields rise above those on longer-term securities, the economy has later entered a recession.
Officials "generally agreed that the current degree of flatness of the yield curve was not unusual by historical standards," particularly given investors' estimates that interest rates will rise to a lower equilibrium level than they have in the past. While some officials raised concern that the yield curve might invert, signaling a recession, others noted that the financial sector didn't express concern about the recent flattening of the yield curve.
Officials also suggested the Fed study new ways to conduct monetary policy given the higher likelihood interest rates will return to zero during the next downturn. Ms. Yellen has previously said the Fed isn't actively entertaining such changes and any discussion around whether to change the framework to instead target a given price level, for example, is likely to fall to her successor. Ms. Yellen's term as chairwoman expires Feb. 3, and Mr. Trump has named Fed governor Jerome Powell to succeed her.