– Fed Policymakers Remain Cautious, Gradual For Now
– Fiscal Stimulus May Affect Future Funds Rate Path
Written exclusively for InTouch Capital Markets
16th November 2017
By Steven K. Beckner
The Federal Open Market Committee meeting we’ve all been waiting for is now at hand — the one at which presumably Federal Reserve policymakers will finally deliver the third increase in the federal funds rate which they’ve been projecting for the past year.
We’ll also find out how many funds rate hikes the FOMC expects to make next year and beyond.
There is not much doubt about the outcome of the Dec. 12-13 FOMC meeting. Financial market participants worldwide would be astounded if the Fed’s policymaking body does not raise the funds rate by 25 basis points to a new target range of 1.25% to 1.50%.
Those market expectations have been reinforced by, most notably, Fed Governor Jerome Powell, President Trump’s nominee to succeed Janet Yellen as Fed Chairman when she steps down in February.
At his Nov. 28 confirmation hearing before the Senate Banking Committee, Powell said he did not want to prejudge the FOMC’s decision, but said, “The case for raising rates at our next meeting is coming together… I think the conditions are supportive of doing that.”
Assuming the FOMC does raise the funds rate, it will be the first time since the Fed began normalizing interest rates that it has followed through on its projections. The FOMC raised the rate only once in 2015 and 2016 after starting those years projecting four rate hikes.
An Interesting Time For The Fed
Needless to say, the FOMC meets at a very interesting time, both in terms of the changes the Committee itself is undergoing and in terms of pending dramatic shifts in the macroeconomic policy mix.
This will be the penultimate FOMC meeting chaired by Janet Yellen, before Powell takes over on Feb. 3 (assuming he is confirmed by the U.S. Senate as he almost certainly will be).
It will also set the stage for a new year that will see other major changes in FOMC composition — most notably a new president of the Federal Reserve Bank of New York and FOMC Vice Chairman, now that William Dudley has announced plans to retire next July.
And there will be a host of other new faces on the Board of Governors. President Trump has nominated esteemed monetary economist Marvin Goodfriend to the Board. That still leaves three other vacancies to fill, including vice chairman.
How a reconfigured FOMC will confront an economy that’s on the verge of getting a major injection of fiscal stimulus will be something to behold.
With major tax cuts inching toward reality, now that both the House and Senate have passed their own versions, FOMC members can more plausibly contemplate implications for the economy and for monetary policy at the upcoming meeting. The very real prospect of enactment of tax cuts is much more likely to figure into FOMC participants’ revised three-year Summary of Economic Projections (SEP) than in the past.
If reduced business and household tax burdens are seen as speeding economic growth, as seems certain to some degree, the officials will also need to factor a faster growth forecast into their assessment of appropriate monetary policy for next year and beyond. That could mean an elevation of the funds rate dot plot.
Factoring In Fiscal Stimulus
Of course, we don’t yet know the final shape of tax reform, and estimates vary as to its likely economic impact.
The Trump administration is promising a full percent or more of additional GDP growth. Members of the National Association for Business Economics are somewhat less exuberant. Eighty-four percent of the forecasters surveyed recently expect tax reform to be enacted before year’s end, but their median estimate of the impact is just two tenths of a percentage point. So the NABE members project growth of just 2.5% next year.
On the other hand, the Congressional Joint Committee on Taxation, which is not known for optimistic forecasts, projects a 0.8 point boost to growth.
Dudley for one has said the prospect of lower taxes will affect his thinking about the economic and monetary policy outlook.
“It would be a reasonable question to ask, is this the best time to apply fiscal stimulus, when the economy’s already close to full employment? It’s probably not the best time,” he told the Wall Street Journal. “If I were to judge that the tax cut package would push the economy along very rapidly without raising the productive capacity of the economy, then that would obviously factor into my own thinking on monetary policy.”
As it is, the economy has picked up steam and is showing some of its old dynamism. Real GDP growth exceeded 3% in the second and third quarters — the first time the U.S. economy has grown that fast in consecutive quarters since 2014. The Atlanta Fed estimates 3.2% fourth quarter growth.
Robust consumer spending and business investment, fueled by improved consumer and business sentiment and deregulation, have spurred growth well above potential.
Policymakers are also very conscious of soaring stock prices. On Nov. 30, the Dow Jones Industrial Average blew through 24,000 — the fifth 1,000-point milestone it has passed this year. The market showed its vulnerability the next day when the Dow fell well over 300 points on news that ex-Trump advisor Michael Flynn pleaded guilty to charges of lying to the FBI. But it also showed resiliency by recovering most of those losses and going on to new highs the following week.
The U-3 unemployment rate stands at a 17-year low 4.1%. The broader U-6 rate has fallen from a recessionary peak above 17% to 7.9%. And other measures of labor market slack are also showing constriction. As Yellen observed in recent testimony before the Congressional Joint Economic Committee, “the labor force participation rate has changed little, on net, in recent years, which is another indication of improving conditions in the labor market, given the downward pressure on the participation rate associated with an aging population.”
True, wages have not risen commensurately, but even there progress has been made. Yellen noted the Employment Cost Index “has moved up a half percentage point the last three or four years,” but said wages have been restrained by “dismal” productivity growth.
The “modest” pace of wage gains shows “labor markets are not significantly overheated,” she said.
If indeed the economy is at or near full employment, as Fed officials keep telling us, what does that mean for monetary policy?
How Gradual Is Gradual?
Powell, Yellen and others have promised further “gradual” interest rate “normalization” — a process that is virtually sure to continue Dec. 13. But is that going to be good enough if tax cuts accelerate expansion and resource utilization? Might “gradual” have to be redefined to avoid overheating?
That question might be a bit premature at a time when some officials and outside observers are talking about needing a pause in rate hikes, given that inflation is still running far below the FOMC’s 2% target and the yield curve is flattening.
St. Louis Federal Reserve Bank President James Bullard is the leading pauser. “Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts,” he declared on Dec. 1, noting that past such inversions have preceded recessions.
“The simplest way to avoid yield curve inversion in the near term is for policymakers to be cautious in raising the policy rate,” Bullard added.
There’s more than one way of looking at fiscal stimulus and its monetary implications.
Conventional wisdom would have it that tax cuts which prospectively bring faster GDP growth and even tighter labor markets require an offsetting reduction of monetary accommodation to avoid an inflationary overheating of the economy, i.e. more aggressive rate hikes than heretofore contemplated.
On the other hand, it could be argued that tax reform will have “virtuous circle” supply-side effects that would enable the economy to grow faster without accelerating inflation. For instance, tax reform could boost already improving business investment and capital formation, leading to a return to more normal productivity growth that might in turn justify greater increases in labor compensation.
If that were the case the FOMC could arguably afford to take a wait-and-see approach and not risk raising rates so rapidly as to snuff out the recovery.
And anyway, a number of Fed officials — Governor Lael Brainard for example — have long argued the Fed can afford to allow an “overshooting” of employment and inflation objectives after a long period of below-target inflation.
Weighing against such a go-slow approach are voices of woe about “waiting too long” in the face of putative asset price bubbles and imbalances.
We’re accustomed to hearing such warnings from hawks like Esther George, the Kansas City Fed president, but recently they came from Dallas Fed chief Robert Kaplan, who had been sounding relatively dovish since voting for the June rate hike.
Advocating a “balanced approach” to monetary policy, Kaplan said, “even though we are not meeting our inflation objective, the size of the expected full employment overshoot is growing and should be taken into account in assessing appropriate monetary policy actions… (C)yclical forces are building, which should increasingly offset the structural forces” restraining inflation.
“I am also mindful that if we wait too long to see actual evidence of inflation, we may get behind the curve and have to subsequently raise rates more rapidly” and “increase the risk of recession,” he went on.
Wanting to “avoid a situation where the FOMC is playing ‘catch-up’ in raising interest rates,” Kaplan said he now believes “it will likely be appropriate, in the near future, to take the next step in the process of removing monetary accommodation.”
Similar warnings have come from others. “The reality is that, if we don’t move interest rates back up to more normal levels, we risk undermining the sustainability of the expansion and creating conditions that could lead to a recession down the road,” said San Francisco Fed President John Williams. “As long as the data continue to show steady growth and we see the uptick in inflation that we’re expecting, my own view is that we should continue to raise interest rates slowly over the coming year.”
Yellen warned the Fed could cause a “boom-bust” situation if, by delaying rate hikes, it “allow(s) the economy to overheat” and then has “to raise rates rapidly.”
Caution Remains the Watchword…For Now
But for now patience and caution seem likely to carry the day for a while longer — not so patient as to hold rate hikes in abeyance but enough to stay on a gradual path of no more than three hikes per year. The pace could conceivably quicken to quarterly or even faster rate hikes but only if the FOMC sees convincing evidence that inflation is moving to target.
Powell seems fully supportive of an approach to higher rates that is cautious but not overly so.
It was appropriate to be “patient” in raising rates during the recession, he told the Senate Banking Committee. But now that the economy is “strong,” “the very low settings for interest rates after the crisis are no longer appropriate. That’s why we’re raising rates on a gradual path, and I expect that will continue.”
Just how gradual remains to be determined and will be subject to change, as we’ve seen over the past few years.
In September, FOMC participants tweaked their funds rate projections modestly. As in the June dot plot, they anticipated a third 2017 rate hike and then three more in 2018, taking the funds rate target range to 2% to 2.25% or a median 2.1%. They reduced their projection for 2019 from 2.9% to 2.7%, but projected the funds rate will reach 2.9% in 2020.
The new dot plot to be released on Dec. 13 seems unlikely to differ substantially from the last one. If anything, faster than expected growth since September puts risks somewhat to the upside.
A related test for the FOMC participants as they compile the revised SEP is to again estimate the longer run or “neutral” funds rate.
In one sense, that rate is esoteric. As a long-time Fed official told me, although the longer run estimates have fallen, “they still don’t justify where we are now” on the funds rate.
But the neutral funds rate is not inconsequential. In effect, it puts a cap on the actual rate path.
In September, the FOMC further reduced its estimate of the neutral rate from 3.0% to 2.8%. Cumulatively, the Committee has lowered the longer run funds rate estimate by 145 basis points since early 2012.
Now, however, the FOMC faces the prospect of an eventual rebound in the neutral rate if stronger business investment leads to greater demand for capital, gooses productivity and increases expectations of returns to capital. It’s doubtful the neutral rate will be raised at this meeting, but the long slide in estimates could be over.
Yellen, along with her former top advisor Williams, have led the way in lowering the longer run funds rate estimate, but she and others have been anticipating a reversal.
“The neutral rate currently appears to be quite low by historical standards, implying that the federal funds rate would not have to rise much further to get to a neutral policy stance,” she told the JEC, but she added, “If the neutral level rises somewhat over time, as most FOMC participants expect, additional gradual rate hikes would likely be appropriate over the next few years to sustain the economic expansion.”
As time goes on, Fed policymakers may have to come to grips with a faster than expected rise in the neutral rate, but that’s a challenge for some future, Powell-led FOMC to confront.
Prior article by Steven Beckner for InTouch Capital Markets: Minutes Not Apt To Show Dominant Opposition To Dec. Rate Hike
Steven Beckner is a veteran financial journalist with four decades of experience of reporting on the Federal Reserve. Mr Beckner is the author of Back From The Brink: The Greenspan Years (Wiley, 1997) and can also be heard speaking regularly on National Public Radio.