Why the Fed is so split on monetary policy

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The minutes from the Sept. 17-18 Federal Open Market Committee meeting, released Wednesday, showed a continued division about rate cuts, both at that meeting and going forward.

“Fed members generally agreed that U.S. economic growth would moderate to around its potential rate in the near term, but they had varying opinions on the magnitude of the impact of uncertainties on the economy and the likelihood of downside risks materializing,” according to Berenberg Capital Markets U.S. Economist Roiana Reid.

“The FOMC minutes exposed differing views on how to handle rate policy going forward,” said Marty Mitchell of The Mitchell Market Report. “Some officials wanted this, several preferred that, yet there was no clear majority noted on what should happen next. It was noted that a few officials felt the market was pricing in too much in the way of rate cuts.”

Inflation was a major topic in the minutes. “FOMC participants appeared more concerned about centering inflation and inflation expectations around the 2% goal, and several participants stressed that inflation expectations may have slipped to levels inconsistent with the 2% goal,” Morgan Stanley researchers noted.

Part of the problem could be “the apparent failure of mainstream economic models to capture fully the current reality,” said Luigi Speranza, BNP Paribas chief global economist. “Most of the models commonly used by practitioners and central bankers suggest inflation should be higher than it in fact is. It is a matter of debate among economists and policymakers whether this now consistent ‘forecast error’ is due to unusually long lags, an under-estimation of economic slack, more structural reasons …, a downward shift in expectations or – as we think is most likely – a combination of all the above.”

And the response to this failure is diverse.

“For some, this suggests the need for caution in the conduct of monetary policy; for others, it is a reason to act pre-emptively and aggressively, even at the risk of overdoing the response,” Speranza wrote in a note. “The Fed is probably in between, as things stand, as it is buying insurance with a cautious stance on its future policy response.”

He listed other challenges for central bankers, including: geopolitics (especially trade issues and Brexit); policy rates near the effective lower bound; and possible ineffectiveness, although “the Fed still has scope to deploy further easing measures aimed at shoring up asset prices, but the risk is that eventually this endeavor proves also to be unsustainable or ineffective.”

Also, pushing for more transparency “might now be backfiring" by adding to volatility, Speranza said. “Traditionally, this transparency related to central banks’ reaction function rather than their action. As the models underlying the economy’s functioning are more uncertain … this distinction is becoming more blurred, causing a number of issues.”

Thursday's data
The consumer price index was steady in September, although it rose 0.1% when excluding food and energy prices, the labor Department reported Thursday. Economists polled by IFR Markets expected the headline number to gain 0.1% and a 0.2% increase in the core number. The miss, suggesting inflation will remain below the Fed’s 2% target, will boost expectations for a third consecutive rate cut when the Fed meets later this month.

Separately, initial jobless claims fell to 210,000 on a seasonally adjusted basis in the week ended Oct. 5 from 220,000 the week before, while continued claims grew to 1.684 million in the week ended Sept. 28 from 1.655 million a week earlier.

Economists projected 219,000 initial and 1.653 million continued claims.

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Monetary policy Economic indicators Jobless claims Federal Reserve FOMC