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Fed Minutes Reveal Uncertainties Over Tax Cuts

Federal Reserve officials in December debated whether new tax cuts would require them to raise short-term interest rates faster this year, after lifting them three times last year.


By

Nick Timiraos

WASHINGTON—Federal Reserve officials in December debated whether looming tax cuts might require them to raise short-term interest rates more aggressively in 2018 than last year, when they lifted borrowing costs three times.

Officials expressed growing confidence in the strength of the labor market and the economy, according to minutes of the Fed’s Dec. 12-13 policy meeting, which were released Wednesday. Since the meeting, Congress approved and President  Donald Trump signed into law a $1.5 trillion tax cut, which could muddy the central bank’s efforts to ensure the economy stays on an even keel.

“Participants discussed several risks that, if realized, could necessitate a steeper path of increases” in their benchmark federal-funds rate, according to the minutes. “These risks included the possibility that inflation pressures could build unduly…perhaps owing to fiscal stimulus or accommodative financial-market conditions,” the minutes said.

After holding the fed-funds rate near zero for seven years, the Fed has raised it five times since late 2015, most recently in December, to a range between 1.25% and 1.5%. They also penciled in three quarter-percentage point rate increases in 2018 and two more moves in 2019.

The Fed is likely to leave rates unchanged at its next meeting, Jan. 30-31. Before the minutes were released, the market for federal-funds futures contracts, where traders bet on the path of interest rates, showed a 62% probability of a rate increase at the central bank’s second meeting of the year, in March.

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The bigger question is how much more the Fed will raise rates through the rest of the year, and the answer largely turns on inflation.

If Fed officials see signs that inflation is rising toward their 2% target over time, they could stick to their tentative plan for three rate increases this year. But if inflation proves weaker, they could move more slowly. And if price pressures pick up more than anticipated, policy makers could act more aggressively.

Even before the tax cut, the Fed’s internal policy debate had been complicated by two puzzles. One was that inflation ran below 2% for much of last year despite strong economic growth and falling unemployment, which reached to 4.1% in November.

At the meeting, officials voted 7-2 to raise rates, with two dissenting because of low inflation. “Some participants observed that there was a possibility that inflation might stay below the objective for longer than they currently expected,” the minutes said.

Still, more officials seemed confident the inflation weakness would prove transitory because they expected pressures from sustained hiring to eventually raise wages and prices.

Earlier

  • U.S. Consumer Spending Rises in November, Savings Rate at 10-Year Low (Dec. 22)
  • Trump Cheers GOP Tax Overhaul, Slams Democrats Who Opposed It (Dec. 20)
  • Fed Raises Rates, Sticks to Forecast for 2018 Increases (Dec. 13)

Christmas may be over but WSJ’s Richard Rubin keeps the holiday spirit alive by explaining who’s getting presents and who’s getting coal with the GOP tax bill.

The other puzzle for policy makers was that financial conditions eased last year—stocks rose, long-term bond yields fell, the dollar weakened—even though the Fed steadily raised short-term interest rates and started paring its $4.5 trillion portfolio of bonds and other assets. Generally in the past, Fed rate increases caused financial conditions to tighten, which helped prevent the economy from overheating.

Some officials have said that if financial conditions don’t tighten eventually, they would want to pick up the pace of rate increases.

The stimulus from the tax overhaul adds yet another factor for Fed officials to consider. At the December meeting, they nudged their economic-growth estimates higher for the next few years on expectations the proposed tax cuts would become law, which they did, the minutes show.

Officials expected the tax changes to boost consumer spending and capital spending, but they thought the magnitude of the effects was uncertain, the minutes said.

An upturn in business investment could increase the economy’s capacity to produce more goods and services without spurring excessive inflation, a development Fed officials would welcome.

But the minutes also show officials weren’t sure how likely it was that the tax changes would induce businesses to invest more, noting companies might instead use higher after-tax profits to reduce debt, buy back stock or acquire other firms. Some business contacts and surveys showed “firms were cautious about expanding capital spending in response to the proposed tax changes,” the minutes said

In the end, their projections suggested they didn’t think then that the economic boost would be so large that they would have to raise rates more than three times this year to guard against too much inflation.

In late 2016, Fed officials projected they would raise rates three times in 2017, and they were able to follow suit because the economy performed largely in line with their forecasts. That wasn’t the case in 2015 and 2016: In each of those years, officials initially projected they would raise rates four times, but concerns about global growth shocks prompted them to move just once at the end of each year.

Write to Nick Timiraos at nick.timiraos@wsj.com

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