US Federal Reserve chairwoman Janet Yellen. Picture: REUTERS
US Federal Reserve chairwoman Janet Yellen. Picture: REUTERS

Washington — The Federal Reserve’s consensus about when to shrink its balance sheet and how to approach policy strategy in a time of low inflation is starting to fragment.

Fed officials continued to view gradual increases in interest rates as appropriate while starting the process of unwinding their $4.5-trillion balance sheet this year, minutes from their June 13-14 meeting released in Washington on Wednesday showed.

But their debate highlighted divisions over the timing of roll-off and unease about recent weak readings on inflation.

"They don’t understand why inflation is so low while they are nearing full employment," said Julia Coronado, president of MacroPolicy Perspectives in New York.

Chairwoman Janet Yellen is trying to manage a deft exit from unprecedented policy stimulus without roiling bond markets or slowing growth. She is also keeping an eye on inflation as slack in the labour market diminishes in what could prove her final year at the helm of the US central bank.

Yellen’s current term expires on February 3 and President Donald Trump has not yet indicated whether he will renominate her, or pick someone else.

Flags fly over the US Federal Reserve headquarters in Washington. Picture: REUTERS
Flags fly over the US Federal Reserve headquarters in Washington. Picture: REUTERS

US unemployment stood at 4.3% in May, a 16-year low and well under the 4.6% that officials estimate representing maximum use of labour resources. For some, such low levels of labour market slack support their forecast that inflation will stabilise near the Fed’s 2% target.

So far, it hasn’t. The annual change on the Fed’s preferred gauge of price pressures was 1.4% in May and the index has been almost continuously below the Fed target more than for five years.

The minutes noted that "most participants viewed the recent softness" in inflation indicators "as largely reflecting idiosyncratic factors".

Fed officials’ baseline outlook is that recent weakness in inflation "is transitory, but they have to formulate a plan if it isn’t", Coronado said.

That plan, according to one wing of the committee, would be to ease back on policy normalisation and wait for prices to rise.

"A few participants who supported an increase in the target range at the present meeting indicated that they were less comfortable with the degree of additional policy tightening through the end of 2018," the minutes said.

"These participants expressed concern that such a path of increases in the policy rate, while gradual, might prove inconsistent with a sustained return of inflation to 2%."

The minutes also showed a split on policy strategy, with about half the committee now supporting a run-it-hot scenario for the labour market.

"Several participants endorsed a policy approach" where the labour market would undershoot their estimate of full employment "for a sustained period".

Meanwhile, several other participants "expressed concern that a substantial and sustained unemployment undershooting might make the economy more likely to experience financial instability or could lead to a sharp rise in inflation".

Investors slightly increased bets on another rate hike this year following the release of the June minutes to roughly two-in-three, according to pricing in federal funds futures contracts, after the key takeaways left policy on track for now.

September versus December

"We continue to expect another rate hike in September followed by the announcement of the balance sheet run-off in December," Harm Bandholz, chief US economist at UniCredit Bank in New York, wrote in a note to clients. "The main risk to this outlook is the that the Fed changes the sequencing of these moves."

The policy committee was divided over when to start a gradual tapering off of its balance sheet, leading to no decision on timing, minutes from the June meeting showed.

"It sounds like there is genuine disagreement over whether sooner or later is better," said Guy Lebas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia.

Bloomberg

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