Inflation remaining low with no noticeable sustainable movement toward the Federal Reserve’s 2% target, plus a flattening yield curve led to Federal Reserve Bank of Minneapolis President Neel Kashkari voting against a rate hike, he wrote in an essay Monday.

Federal Reserve Bank of Minneapolis President Neel Kashkari.
Federal Reserve Bank of Minneapolis President Neel Kashkari. Bloomberg News

The labor market has tightened since we raised rates in June, but inflation is not rising. It doesn’t appear that we are sustainably moving closer to our inflation target,” Kashkari wrote in the essay published on the Minneapolis Fed website. “Inflation expectations are low and may have already fallen. Monetary policy is currently only somewhat accommodative. There don’t appear to be urgent financial stability risks at the moment. The global environment seems to have a fairly typical level of risk. One new development is the flattening yield curve, which is also urging caution. From a risk management perspective, we have stronger tools to deal with high inflation than low inflation. Looking at all of these factors together led me to vote against a rate increase.”

This was Kashkari’s third dissent on rate hikes this year. In March and June, he voted against a hike because there was no evidence of growing inflation and there appeared to be labor market slack remaining. “Since then, instead of rising, inflation has actually fallen to 1.6%. Now a new concern is emerging: In response to our rate hikes, the yield curve has flattened significantly, potentially signaling an increasing risk of a recession,” he wrote. “Together, these factors make a compelling case that the FOMC should not increase rates further until we are much more confident that inflation is returning to our target.”

Calling the situation “perplexing,” Kashkari noted despite great strength in the labor market, “wage growth and inflation have been muted.” He suggested: “the job market is not as tight as the 4.1 percent unemployment rate suggests and that people’s expectations for future inflation have fallen, which can become self-fulfilling.”

Looking past the headline unemployment rate, and concentrating on the participation rate for workers between 25 and 54 years old, “suggests that there could be more than a million workers still on the sidelines,” Kashkari noted. “We don’t know how many will return, but with wage growth still well below its precrisis pace, it’s easy to argue that we might not really be at full employment. If wage growth climbs, I expect to see more people come into the labor force.”

Kashkari said since June incoming data “have only heightened my concerns. What is new is the flattening yield curve, the difference between 10-year and 2-year Treasury yields, which has fallen from around 1.45 percent before the [Federal Open Market Committee] started raising rates in late 2015, to approximately 0.51 percent today. An inverted yield curve, where short rates are above long rates, is one of the best signals we have of elevated recession risk and has preceded every single recession in the past 50 years. While the yield curve has not yet inverted, the bond market is telling us that the odds of a recession are increasing and that inflation and interest rates will likely be low in the future. These signals should caution the FOMC against further rate increases until it becomes clear that inflation is actually picking up.”

By raising rates without the need increase in inflation “could needlessly hold down wage growth while potentially increasing the chance of a recession,” he said.

Turning to tax policy, Kashkari said he hadn’t “factored major fiscal policy changes into my economic and policy forecasts because there was too much uncertainty as to whether, when and how large any fiscal changes would be. But given that the House and Senate have both passed major pieces of tax legislation, I have now incorporated the tax package into my economic forecast. The expected effects on supply and demand do not appear large enough at this point to change my expected path for monetary policy. If the economic effects end up larger than expected, I will adjust my policy forecast when that becomes clear.”

Kashkari held out the possibility that there could be an upside surprise on inflation, which would require increasing “rates more aggressively.” While some FOMC participants say “gradual rate increases are better than waiting and having to move aggressively. It isn’t clear to me that one path is obviously better than the other.”

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