Participants' Views on Current Conditions and the Economic Outlook
In their discussion of the economic situation and the outlook, meeting participants agreed that information received over the intermeeting period indicated that the labor market had continued to strengthen and that economic activity had continued to expand at a moderate pace. Job gains had remained solid, and the unemployment rate had stayed near its recent low. Household spending had continued to rise moderately, while business fixed investment had remained soft. Measures of consumer and business sentiment had improved of late. Inflation had increased in recent quarters but was still below the Committee's 2 percent longer-run objective. Market-based measures of inflation compensation remained low; most survey-based measures of inflation compensation were little changed on balance.
Participants generally indicated that their economic forecasts had changed little since the December FOMC meeting. They continued to anticipate that, with gradual adjustments in the stance of monetary policy, economic activity would expand at a moderate pace, labor market conditions would strengthen somewhat further, and inflation would rise to 2 percent over the medium term. They also judged that near-term risks to the economic outlook appeared roughly balanced. Participants again emphasized their considerable uncertainty about the prospects for changes in fiscal and other government policies as well as about the timing and magnitude of the net effects of such changes on economic activity. In discussing the risks to the economic outlook, participants continued to view the possibility of more expansionary fiscal policy as having increased the upside risks to their economic forecasts, although some noted that several potential changes in government policies could pose downside risks. In addition, several viewed the downside risks from weaker economic activity abroad as having diminished somewhat. But several indicated that they continued to be concerned about the downside risks to economic activity associated with the possibility of additional appreciation of the foreign exchange value of the dollar or financial vulnerabilities in some foreign economies, together with the proximity of the federal funds rate to the effective lower bound. Regarding the outlook for inflation, some participants continued to be concerned that faster-than-expected economic growth or a substantial undershooting of the longer-run normal unemployment rate posed upside risks to inflation. However, several others continued to see downside risks to the inflation outlook, citing still-low measures of inflation compensation and inflation expectations or the possibility of further appreciation of the dollar. Participants generally agreed that the Committee should continue to closely monitor inflation indicators and global economic and financial developments.
Regarding the household sector, consumer spending posted a moderate increase in the fourth quarter, and participants generally anticipated that further gains in consumer spending would contribute importantly to economic growth in 2017. They expected that, although interest rates had moved higher, household spending would continue to be supported by rising employment and income as well as high levels of household wealth. The recent improvement in consumer sentiment was also viewed as a potentially positive factor in the outlook for spending, although several participants cautioned that an elevated level of sentiment, even if it was sustained, was likely to make only a small contribution to household spending beyond those from income, wealth, and credit conditions.
Recent indicators of activity in the housing sector were generally positive. Starts and permits for single-family housing and sales of existing homes rose moderately in the fourth quarter, and real residential investment bounced back after two quarterly declines. A couple of participants commented that supply constraints might be holding back new homebuilding. In addition, a few participants noted that prospects for residential investment would also depend on whether household formation picked up and how housing market activity responded to the recent rise in mortgage interest rates.
The outlook for the business sector improved further over the intermeeting period. Business investment in E&I, which had been contracting earlier in 2016, increased at a moderate rate in the fourth quarter. In addition, new orders for nondefense capital goods posted widespread gains in recent months. The available reports from District surveys of activity and revenues in the manufacturing and services industries were very positive. Moreover, a number of national surveys of sentiment among corporate executives and small business owners as well as information from participants' District contacts indicated a high level of optimism about the economic outlook. Many participants indicated that their business contacts attributed the improvement in business sentiment to the expectation that firms would benefit from possible changes in federal spending, tax, and regulatory policies. A few participants indicated that some of their contacts had already increased their planned capital expenditures. However, participants' contacts in some Districts, while optimistic, intended to wait for more clarity about federal policy initiatives before adjusting their capital spending and hiring. In addition, contacts in some industries remained concerned that their businesses might be adversely affected by some of the government policy changes being considered. Activity in the energy sector continued to improve, with District contacts reporting an increase in capital spending, better access to credit, and a pickup in hiring. However, reports from a couple of Districts indicated that the agricultural sector was still weak, with low commodity prices continuing to put financial pressure on farm-related businesses.
The labor market continued to strengthen in recent months. Monthly gains in nonfarm payroll employment averaged 165,000 over the period from October to December, a pace that, if it continued, would be expected to increase labor utilization over time. At 4.7 percent in December, the unemployment rate remained close to levels that most participants judged to be consistent with the Committee's maximum-employment objective. Some participants cited other indicators confirming the strengthening in the labor market, such as a decline in the broader measures of labor underutilization that include workers marginally attached to the labor force, the rise in the quits rate, and faster increases in some measures of labor compensation. Moreover, several participants' business contacts reported shortages of workers in some occupations or the need for training programs to expand the supply of skilled workers. Several other participants thought that some margins of labor underutilization remained, citing the still-high rate of prime-age workers outside the labor force, the elevated share of workers who were employed part time for economic reasons, or the potential for further firming in labor force participation. However, a couple of participants pointed out that the uncertainty attending estimates of longer-run trends in part-time employment and labor force participation made it difficult to assess the scope for additional increases in labor utilization. Most participants still expected that if economic growth remained moderate, labor markets would continue to tighten gradually, with the unemployment rate running only modestly below their estimates of the longer-run normal rate. However, several participants projected a more substantial undershooting.
Information on inflation received over the intermeeting period was broadly in line with participants' expectations and was consistent with a view that PCE inflation was moving closer to the Committee's 2 percent objective. The 12-month change in headline PCE prices increased further, to 1.6 percent in December, as the effects of the earlier declines in consumer energy prices waned. The 12-month change in core PCE prices stayed near 1.7 percent for a fifth consecutive month. A few participants noted that other measures provided additional evidence that inflation was approaching the Committee's objective; for example, the 12-month changes in the headline and core CPI, the median CPI, and the trimmed mean PCE price index had also moved up from year-earlier levels. The available information on pricing from District business contacts varied, with a couple of participants reporting that firms were experiencing rising cost pressures from input costs or had been able to raise their prices, while a few other participants said that firms in their Districts were not experiencing price pressures or that the appreciation of the dollar was continuing to hold down import prices. Most survey-based measures of longer-term inflation expectations had been little changed in recent months. The median response to the Michigan survey of longer-run inflation expectations moved back up to 2.6 percent in January, in line with the average of readings during 2016, and the measure at the three-year horizon from the Federal Reserve Bank of New York's survey rose slightly in December; the measures calculated by the Federal Reserve Bank of Cleveland had been stable over the preceding three months. Some market-based measures of inflation compensation had turned up noticeably in late 2016, but a number of participants noted that they remained relatively low. Most participants continued to expect that inflation would rise to the Committee's 2 percent objective over the medium term. Some saw a risk that inflationary pressures might develop more rapidly than currently anticipated as resource utilization tightened, while several others thought that progress in achieving the Committee's inflation objective might lag if further appreciation of the dollar continued to depress non-energy commodity prices or if inflation was slow to respond to tighter resource utilization.
Financial conditions appeared to have changed little, on net, in recent months: Equity prices had risen and credit spreads had narrowed, but longer-term interest rates had increased and the dollar had appreciated further. In their discussion, participants considered how recent developments had affected their assessment of the stability of the U.S. financial system. Overall, valuation pressures appeared to have risen for some types of assets, while financial-sector leverage remained low and risks associated with maturity and liquidity transformation had declined. A few participants commented that the recent increase in equity prices might in part reflect investors' anticipation of a boost to earnings from a cut in corporate taxes or more expansionary fiscal policy, which might not materialize. They also expressed concern that the low level of implied volatility in equity markets appeared inconsistent with the considerable uncertainty attending the outlook for such policy initiatives.
Recent reforms had diminished the risk of runs on or by prime money market funds. However, it was noted that other risks to financial stability might arise as the structure of funding markets evolved or if real estate asset values declined sharply. More broadly, it was pointed out that an environment of low interest rates and a relatively flat yield curve, if it persisted, had the potential to boost incentives to take on leverage and risk. Several participants emphasized that the increased resilience of the financial system since the financial crisis had importantly been the result of the key safety and soundness reforms put in place in recent years. However, having additional macroprudential tools could prove useful in addressing problems that could arise in real estate financing or in the shadow banking sector.
Participants discussed whether their current assessments of economic conditions and the medium-term outlook warranted altering their earlier views of the appropriate path for the target range for the federal funds rate. Participants generally characterized their economic forecasts and their judgments about monetary policy as little changed since the December meeting. Against this backdrop, they thought it appropriate to maintain the target range for the federal funds rate at 1/2 to 3/4 percent at this meeting.
Most participants continued to judge that, while the outlook was subject to considerable uncertainty, a gradual pace of rate increases over time was likely to be appropriate to promote the Committee's objectives of maximum employment and 2 percent inflation. Some participants viewed a gradual pace as likely to be warranted because inflation was still running below the Committee's objective or because the proximity of the federal funds rate to the effective lower bound placed constraints on the ability of monetary policy to respond to adverse shocks to the aggregate demand for goods and services. In addition, it was noted that the downward pressure on longer-term interest rates exerted by the Federal Reserve's asset holdings was expected to diminish in the years ahead in light of an anticipated gradual reduction in the size and duration of the Federal Reserve's balance sheet. Finally, the view that gradual increases in the federal funds rate were likely to be appropriate also reflected the assessment that the neutral real rate--defined as the real interest rate that is neither expansionary nor contractionary when the economy is operating at or near its potential--was currently quite low and was likely to rise only slowly over time.
Participants emphasized that the Committee might need to change its communications regarding the anticipated path for the policy rate if economic conditions evolved differently than the Committee expected or if the economic outlook changed. They pointed to a number of risks that, if realized, might call for a different policy trajectory than they currently thought most likely to be appropriate. These included upside risks such as appreciably more expansionary fiscal policy or a more rapid buildup of inflationary pressures, as well as downside risks associated with a possible further appreciation of the dollar or financial vulnerabilities in some foreign economies, together with the proximity of the federal funds rate to the effective lower bound. Moreover, most participants continued to see heightened uncertainty regarding the size, composition, and timing of possible changes to fiscal and other government policies, and about their net effects on the economy and inflation over the medium term, and they thought some time would likely be required for the outlook to become clearer. A couple of participants argued that such uncertainty should not deter the Committee from taking further steps in the near term to remove monetary policy accommodation, because fiscal and other policies were only some of the many factors that were likely to influence progress toward the Committee's dual-mandate objectives and thus the appropriate course of monetary policy. However, other participants cautioned against adjusting monetary policy in anticipation of policy proposals that might not be enacted or that, if enacted, might turn out to have different consequences for economic activity and inflation than currently anticipated.
In discussing the outlook for monetary policy over the period ahead, many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations or if the risks of overshooting the Committee's maximum-employment and inflation objectives increased. A few participants noted that continuing to remove policy accommodation in a timely manner, potentially at an upcoming meeting, would allow the Committee greater flexibility in responding to subsequent changes in economic conditions. Several judged that the risk of a sizable undershooting of the longer-run normal unemployment rate was high, particularly if economic growth was faster than currently expected. If that situation developed, the Committee might need to raise the federal funds rate more quickly than most participants currently anticipated to limit the buildup of inflationary pressures. However, with inflation still short of the Committee's objective and inflation expectations remaining low, a few others continued to see downside risks to inflation or anticipated only a gradual return of inflation to the 2 percent objective as the labor market strengthened further. A couple of participants expressed concern that the Committee's communications about a gradual pace of policy firming might be misunderstood as a commitment to only one or two rate hikes per year and stressed the importance of communicating that policy will respond to the evolving economic outlook as appropriate to achieve the Committee's objectives. Participants also generally agreed that the Committee should begin discussions at upcoming meetings about the economic conditions that could warrant changes in the existing policy of reinvesting proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities, as well as how those changes would be implemented and communicated.