While the dollar and TSY yields both dropped to session lows shortly after the FOMC announcement hit as traders focused on the Fed disclosure that FOMC voters thought it prudent to await evidence an "economic slowdown is transitory" suggesting the committee still wanted to hike rates but was willing to wait for the certainty of data, Goldman's disagreed and according to a just released assessment by Goldman's Jan Hatzius, the statement was more hawkish than perceived by the market.
Specifically, Hatzius claims that the May FOMC minutes mirrored the statement in "downplaying the weak Q1 GDP print and the soft March inflation data, and also noted that most participants judged that “it would soon be appropriate” for the FOMC to hike again."
Hatzius also pointed out what he highlighted earlier, namely that the minutes contained new information about the eventual process for phasing out reinvestment, which will likely occur by “preannouncing a schedule of gradually increasing caps to limit the amounts of securities that could run off in any given month.”
As a result, Goldman continues to see "an 80% probability of a rate hike at the June meeting and expect this to be followed by another rate hike in September and the announcement of balance sheet normalization at the December meeting. However, we see the risks to the timing of the balance sheet announcement as skewed toward the September meeting."
Here are the key points from his note:
- The minutes to the May FOMC meeting mirrored the statement in downplaying the weak Q1 GDP print as “likely to be transitory,” and also noted that “most participants judged that if economic information came in about in line with their expectations, it would soon be appropriate for the Committee to take another step in removing some policy accommodation.” Although the minutes noted that FOMC members judged it “prudent to await additional evidence indicating that the recent slowing” in growth is transitory, we view this as a fairly low bar that the data thus far have met.
- Notably, “several participants” pointed to conditions that could justify a “somewhat more rapid” removal of policy accommodation, such as a faster-than-expected decline in the unemployment rate, a faster increase in wage growth, or highly stimulative fiscal policy changes. This comment might be a bit dated in light of the deterioration of the prospects for fiscal stimulus in recent weeks. On the other side, “a couple” noted that a more gradual pace of tightening might be warranted, especially if inflation proved not very sensitive to a lower unemployment rate.
- On inflation, the minutes noted that “most participants” viewed the soft March data as primarily reflecting “transitory factors” and specifically downplayed “idiosyncratic factors such as a large drop in the measure of quality-adjusted prices for wireless telephone services.” Participants generally thought that inflation would stabilize around 2 percent, though a few “expressed uncertainty about the reasons for the recent unexpected weakness” and its implications for the inflation outlook. On the other hand, “a couple” expressed concern that undershooting full employment “could pose an appreciable upside risk to inflation.” Overall, the minutes implied that participants generally saw the inflation outlook as “little changed,” though we note that these comments are somewhat dated at this point following a second soft CPI report for April.
- The minutes provided new information about the process for phasing out reinvestment, noting that “nearly all” participants supported a staff proposal of “preannouncing a schedule of gradually increasing caps to limit the amounts of securities that could run off in any given month.” The minutes did not clarify how long the phase-in would take or how large the final peak cap would be. While this proposal differs from our prior expectation of a percentage phase-out, the difference appears to be more stylistic than substantive. We interpret the proposal for dollar amount caps as a prudent response to reduce variability associated with MBS prepayment and the irregular monthly schedule of maturing assets. The minutes noted that with a preannounced schedule, the phase-out process “could likely proceed without a need for the Committee to make adjustments as long as there was no material deterioration in the economic outlook,” implying a fairly strong bias toward sticking to the schedule once announced.
- We continue to see an 80% probability of a rate hike at the June meeting. We also continue to expect another rate hike in September, followed by the announcement of balance sheet normalization at the December meeting. However, we see the risks to the timing of the balance sheet announcement as skewed toward the September meeting, in which case the third rate hike of the year would likely be deferred.
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Elsewhere, Citi economists issued a comparable note according to which the risk of a September balance sheet announcement has also been brought forward, relative to the baseline December expectation.
"The fact that operational details are closer to being specified shows that the FOMC could be ready to announce tapering of its balance sheet earlier than previously expected. This increases the risk of a September announcement relative to our current view for an announcement in December" said Citi economist Andrew Hollenhorst.
They also note that, like Goldman's reading of the minutes, the FOMC members see Q1 weakness as transitory, and note that the statements on inflation.
"On transitory Q1 growth weakness: “Members generally judged that it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory before taking another step in removing accommodation”. But also: “Most participants judged that if economic information came in about in line with their expectations, it would soon be appropriate to take another step in removing some policy accommodation.” In our view, positive economic activity data since the meeting corroborate the view that Q1 GDP weakness was transitory. This is consistent with our expectation that the Fed will hike in June."
Furthermore, Citi focuses on the read through from the recent weak inflation print. It says:
On (1), “most participants” viewed recent softer inflation data as primarily reflecting transitory factors with a “few” expressing concerns that progress on the inflation mandate had slowed.
On (2), a “few” participants continued to anticipate a substantial undershooting of the unemployment rate, and “several” point to the possibility for the need of a more rapid removal of accommodation, for instance, if the unemployment rate fell appreciably further, or if wages increased faster than expected, or if stimulative fiscal policy were enacted.
According to Hollenhorst these statements, even read in the context that inflation softened further and the unemployment rate fell since the meeting, appear to imply that unemployment rate undershoot is not a major concern while recent inflation softness is generally viewed as transitory.
Bottom line, Citi read the May minutes as neutral with the "discussion around balance sheet reduction was the most interesting part with earlier-than-expected details of a general plan" and reiterates the bank's call remains for hikes in June and September with balance sheet reduction announced in December, although it may come as soon as September.
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Finally, here is Stone McCarthy:
- The minutes from the May 2-3 FOMC meeting strongly support our view that the FOMC will raise interest rates and announce its balance sheet normalization plans at the upcoming June 13-14 FOMC meeting. In line with our expectation, “nearly all” Fed officials agreed it is “likely appropriate” to begin reducing the balance sheet later this year.
- Consistent with a gradual implementation of a “passive and predictable” unwind of the balance sheet, policy makers are considering a “preannounced schedule of gradually increasing caps to limit the amount of securities that could run off” the balance sheet in any given month. Initially, this appears to be a more gradual phase-in than we assumed in our base-case scenario.
- In line with our expectation, Fed officials signalled they will likely begin to reduce the balance sheet later this year and the details of their final plan could be announced soon – we anticipate that happening at the upcoming June 13-14 FOMC meeting. Consistent with a gradual implementation of a “passive and predictable” unwind of the balance sheet, policy makers are considering a proposal for "a set of gradually increasing caps, or limits, on the dollar amounts of Treasury and agency securities that would be allowed to run off each month, and only the amounts of securities repayments that exceeded the caps would be reinvested each month". Initially, this appears to be a more gradual phase-in than we assumed in base-case scenario. In our base-case scenario we assumed that the FOMC would phase-in the reduction in debt reinvestments by allowing 50% of the maturing Treasury and MBS securities to roll-off in the first year of implementation. However, starting in the second year, the FOMC’s plan might be in line with our view in which there is a full ceasing of debt reinvestments.
- Beyond June, assuming the current political chaos does not greatly dampen economic activity via a negative confidence shock, we look for another rate hike in September. This would lift the mid-point of the Fed funds target range to 1.38%. Our read of the minutes provides support for this call, though some policy makers “judged that it would be prudent to await additional evidence” that slower growth was transitory. Our forecast that real GDP growth rebounds above 3% (annualized) in Q2 argues for another rate hike in September. Thereafter, in Q4, the FOMC could initiate balance sheet reduction and refrain temporarily from lifting the Fed funds rate during the quarter.