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Fed ready to begin unwinding stimulus ‘within months’

US Federal Reserve policymakers are ready to press ahead with the unwinding of its crisis-era economic stimulus programme within months, as they gear up to shrink the central bank’s swollen balance sheet in spite of a spate of weak inflation readings. 

Minutes of their June rate-setting meeting showed the Fed divided over the exact timing of the move, with a number of officials suggesting they did not want to act any sooner than September. But several officials warned that allowing unemployment to fall too low could lead to the US economy overheating or the emergence of financial excesses. 

The record of the meeting on June 13-14, released on Wednesday, reveals the Fed in a hawkish mood and comes as central bankers in several rich nations hint at withdrawing some of the crisis-era monetary stimulus. The prospect of tighter policy has provoked an anxious mood in financial markets that have become habituated to years of cheap money. 

Last week Mario Draghi, the European Central Bank president, gave a speech that appeared to declare victory over deflation, while Mark Carney of the Bank of England was interpreted as favouring a rate rise. Some traders have spoken of a mini taper tantrum in the markets, alluding to a sell-off in 2013 inadvertently prompted by Ben Bernanke, the Fed’s then-chairman. 

However, investor reaction to the minutes proved a relatively muted one, with the yield on the benchmark ten-year Treasury edging 2 basis points higher to 2.35 per cent following their release before easing to 2.33 per cent in early trading in London.

“The market took away a modestly more hawkish message regarding an additional 2017 hike,” fixed-income strategists at TD Securities noted. “The market will look to the June payroll report for further direction.” The jobs report for June is released on Friday. Meanwhile, the dollar index, a broad measure of the US currency, was little changed on Thursday morning.

The Fed’s meeting predated the recent market fluctuations, but the US central bank has been at the forefront of the move to reduce the monetary accommodation put in place at the height of the financial crisis. 

The minutes said that several Fed officials wanted to announce the start to the process of reducing asset holdings within “a couple of months” — pointing to this month’s meeting on July 25-26 — and it was noted at the meeting that the central bank’s communications efforts had already prepared the markets for the step. 

However others wanted to wait longer as they assess the outlook for economic activity and inflation. Expectations remain centred on a move at the September 19-20 meeting, with some rate-setters arguing that a further rate increase should follow in December. 

Janet Yellen, the Fed chair, said at her June press conference that a move could come “relatively soon”. 

There was a muted market reaction to the minutes, with the yield on the US two-year Treasury note falling at first, only to reverse course and trade flat at 1.41 per cent. Stocks were little changed and the dollar was trading 0.1 per cent higher.

The Fed has already lifted rates four times from the post-crisis lows, including a further quarter point at the latest meeting. In recent months it has been heralding the gradual withdrawal of quantitative easing later this year, and at the June meeting set out detailed plans to do so.

Ms Yellen has the opportunity to clarify the outlook in Congressional testimony on Wednesday and Thursday next week. With inflation disappointing for three months in a row, the minutes revealed an intense debate over why price growth had been sluggish. Most participants decided the softness reflected “idiosyncratic factors” including the falling prices of wireless telephony and drugs, and said they expected inflation to head back to target over the medium term.

However, several expressed concern that progress to the 2 per cent objective had slowed, underscoring the divisions in the Fed over how to interpret persistently below-target inflation.

Supportive financial conditions have been helping counterbalance the poor inflation readings for many policymakers, and the meeting dwelled both on elevated equity prices and the reasons for low bond yields. Some participants thought that “increased risk tolerance” among investors may be pushing asset values higher, while a few worried openly that low volatility in markets could “lead to a build-up of risks to financial stability”.

Against that backdrop, the Fed policymakers generally supported further rate increases, but they were divided as to the pace. Some argued that plans for reducing the size of the balance sheet were a reason to believe that rate increases would consequently follow a more shallow path than otherwise.

Fed officials were also divided as to whether they should be comfortable with the unemployment rate persistently undershooting their estimates for the long-term jobless rate. Some said this would help boost wage inflation by keeping the labour market tight.

However several expressed concern that a “substantial and sustained unemployment undershooting” might stoke up financial instability risks or lead to a sharp rise in inflation, which would force the Fed to jack up rates more aggressively down the line.

Last week Ms Yellen noted that some asset prices were “somewhat rich” — in words that suggested the Fed is watching developments in financial markets closely.