The minutes of the Federal Open Market Committee’s October meeting offered a surprise. No, not a surprise about the likelihood the Federal Reserve hikes at the next meeting. A reading of these minutes both confirmed that this committee expects it will hike in December and that the members clearly wanted to send that message. Message received!
The surprise was the revelation that the Fed’s staff of Ph.D. economists has done an exhaustive study of the “neutral” real policy rate – which they wonkishly call “r*” – and the study concluded that 1) the neutral policy rate is time varying, 2) it is about 0% right now, 3) it is expected to rise only “gradually” over time and 4) it is unlikely to rise to levels seen before the financial crisis. Moreover, while this was a staff study, a “number of participants” at the October FOMC meeting agreed with these conclusions.
So it has taken 18 months, but the minutes released today make clear that the Fed has now converged to PIMCO’s view, first developed at our May 2014 Secular Forum and revisited at the May 2015 Secular Forum, that monetary policy will be operating according to a new paradigm for the neutral policy rate for at least the next three to five years. We call this The New Neutral.
These minutes validate the rather hawkish tone we inferred from the October Fed statement and Chair Janet Yellen’s subsequent comments before Congress. While the doves would like to see further improvement in the labour market and inflation that is closer to the Fed’s long-run 2% objective, they, like the rest of the committee, understand that there is a greater issue at hand. In the words of the FOMC, a delay in tightening could “magnify the perceived importance of the beginning of the policy normalization process.”
Barring any unanticipated market shocks, the FOMC has essentially locked itself into a December hike. Now its task is to ensure that market participants are ready and understand that this will be the most dovish rate hike ever.