The View from D.C.

Heading into the second half of the year, there are a number of key policy uncertainties in Washington. For the Fed, a clear near-term picture is a contrast to the longer-term outlook where views of the market and the Fed have diverged. On Capitol Hill, the repeal and replacement of the Affordable Care Act is still seen as a key hurdle to tackling tax reform and there’s haste to get the ACA repeal done before the July 4 recess. In the months ahead, Congress will have to address the debt ceiling and complete a budget. Lawmakers view Trump tweets and potential charges of obstruction of justice as possible impediments to advancing the agenda.

At the June policy meeting, the Fed laid out its plan to begin unwinding the balance sheet. No start date was specified, but there’s a strong consensus among economists that it will begin in October (to be announced at mid-September policy meeting). The Fed announced starting caps ($6 billion for Treasuries, $4 billion for mortgage-backed securities) for how much will be allowed to run off each month. The Fed will then increase those caps every three months until it reaches $50 billion per month ($30 billion in Treasuries, $20 billion in MBS). Starting slow, the markets shouldn’t have much difficulty, but once the drawdown hits its stride ($600 billion per year), there may be some trouble in absorbing that. The bond market hasn’t reacted much to the Fed’s balance sheet plans. Some of it was likely already baked in, but the markets also seems to doubt that the balance sheet drawdown will proceed as planned.

Economists generally expect the Fed to refrain from raising rates at the September policy meeting to give the balance sheet drawdown an unobstructed runway. However, most expect a resumption of rate increases at the mid-December policy meeting. Beyond that, the outlook is more clouded, partly because we will see a number of personnel changes at the Fed.

Judging from the federal funds futures market, the odds of another 25-basis-point rate increase by year end are somewhat below 50%. There has been some criticism of the Fed’s June rate hike, which came amid a string of softer economic growth figures and low inflation readings. Here’s the Fed’s thinking. At 4.3%, the unemployment rate is below the long-term equilibrium rate (which the Fed pegs at 4.6%, down from 4.8% seen a just a couple of quarters ago). The Fed firmly believes in the Phillips curve, which describes a relationship between the unemployment rate and accelerating inflation. However, while the principles behind that relationship are basic (it’s supply and demand), the slope of the curve may be flat with some nonlinearity further away from the equilibrium unemployment rate (meaning that at some point, a declining unemployment rate will lead to a much faster pickup in inflation). Inflation is still below the Fed’s 2% goal, but suppose it stays low. The Fed could refrain from raising rates, pushing the unemployment rate lower to boost inflation, but then would have to raise rates later to get back to the equilibrium unemployment rate – a path that would be hazardous (risking a recession). There may be some uncertainty about the equilibrium unemployment rate, but given the balance of policy risks, a gradual path of rate increases is appropriate. If wrong, then the Fed hasn’t raised rates much.