Fed Minutes Draw Mixed Reaction from Financial Markets

The release of the latest Federal Reserve minutes triggered a two-sided reaction in the financial markets as it offered a little of something for both the bulls and the bears.

Fed Split on Inflation

The minutes indicated that central bank officials were increasingly split on the outlook for inflation and how it might affect the future pace of interest rates. Some Fed officials continued to press for higher interest rates despite sluggish inflation figures, which they considered to be temporary and likely to rise over the long run to a targeted level of 2 percent.

“Most participants viewed the recent softness in these price data as largely reflecting idiosyncratic factors…however, several participants expressed concern that progress…might have slowed and that the recent softness in inflation might persistent,” the Fed said in the minutes.

Fed on Financial Stability Risk

The Federal Open Market Committee questioned why financial conditions had not tightened despite recent rate rises and a few said equity prices were elevated. Rather than causing conditions to tighten, they actually have grown looser since the central bank embarked on a series of hikes.

FOMC members “Suggested that increased risk tolerance among investors might be contributing to elevated asset prices more broadly; a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability.”

The meeting minutes showed there was considerable discussion over why despite the Fed raising its benchmark rate target four times since December 2015, government bond yields continue to decline. Stocks also continued to gain in the second-longest bull market ever recorded, and multiple other measures of financial conditions remain loose.

No Timetable for Unwinding Balance Sheet

The Fed minutes did not reveal a timetable on when the central bank would begin unwinding its balance sheet. Fed Chair Janet Yellen has said in the past that the hope is to have the balance sheet reduction happen in “the background” with little notice from markets.  The shedding of the bonds and other securities, most of which were purchased in the wake of the 2007-2009 financial crisis, marks the final chapter in the central bank’s normalization of monetary policy.

The issue of when to begin reducing the Fed’s $4.2 trillion portfolio of Treasury bonds and mortgage-backed securities and how it might affect determining future rate hikes also sparked debate.

The minutes indicated that several Fed officials felt the reduction in the balance sheet and associated policy tightening “was one basis for believing that…the target range for the federal funds rate would follow a less steep path than it otherwise would.” Some others, however, said the shedding of bonds should not figure heavily in deciding monetary policy.