Written exclusively for InTouch Capital Markets
26th April 2018
By Steven K. Beckner
There is almost no chance the Federal Reserve will raise interest rates at its third Federal Open Market Committee meeting of the year, but the deliberations of Chairman Jerome Powell and his fellow policymakers will still be important.
We won’t know the content of their discussions until three weeks after the May 1-2 meeting, but can imagine their tenor — an amalgamation of optimism, uncertainty, caution and patience. There’s little sentiment for radically ramping up credit tightening.
Everyone wants to know whether the FOMC will raise the federal funds rate three or four times this year and how restrictive policy will ultimately become. But Fed officials themselves don’t know and are slightly bemused by the speculation.
Chicago Fed President Charles Evans recently acknowledged those are “the most popular questions” he gets, but exclaimed, “I can’t answer these questions! The details of our story have not been written yet, and details matter.”
At the upcoming meeting officials will strive to get the best perspective on those “details” they can in a bewildering environment.
It’s too soon after it raised the funds rate to a 1.50% to 1.75% target range on March 21 for the Fed to raise it again, but that doesn’t render this meeting meaningless.
The FOMC, which has raised that rate 150 basis points since leaving zero in December 2015, has given itself loose guidelines for raising it 25 basis points at least two more times this year, but timing is unsure.
Fed watchers rightly expect rate moves to happen quarterly when a Summary of Economic Projections and Chairman’s press conference are scheduled. So additional moves will likely come at the June 12-13, September 15-26 and/or December 18-19 meetings.
We won’t get a SEP or press conference May 2, but the value of these interim meetings is that they give officials an opportunity to take stock of their forecasts and rate projections in light of changes in economic and financial conditions since they last met and reevaluate their strategy.
They give Powell a chance to build support for later action. Forming a consensus can take time.
In raising the funds rate in March, the FOMC modestly boosted its economic forecasts and moved toward a quicker tightening pace, but not as fast as some supposed.
The minutes say a stronger outlook “implied that the appropriate path for the federal funds rate over the next few years would likely be slightly steeper than they had previously expected.” All participants “expected inflation on a 12-month basis to move up in coming months.”
However, they add, “the increase in the inflation rate arising from this source was widely expected and, by itself, would not justify a change in the projected path for the federal funds rate.”
Although the FOMC lifted rate projections, they can’t be called aggressive. As in December, six participants projected three 2018 rate hikes. Three more anticipated four moves. The top of the range remained at 2.6%, and the median funds rate for the end of this year stayed 2.1%.
The median rate projection of participants, including non-voters, for the end of 2019 rose only two tenths to 2.9%; for 2020 just three tenths to 3.4%
Simultaneously, officials inched up GDP forecasts, lowered unemployment forecasts and anticipated the price index for personal consumption expenditures (PCE) will hit 2% next year.
There is understandable ambivalence about how many rate hikes will be required.
FOMC forecasts are predicated on “appropriate monetary policy.” Each official projects growth, unemployment and inflation based on a best guess of the funds rate trajectory needed to realize them. The Fed then measures forecasts against incoming information.
`For the Fed to become more aggressive, the economy must surpass expectations. If forecasts based on “appropriate monetary policy” assumptions are merely fulfilled why alter those assumptions?
Predicting how many times the Fed will raise rates this year or beyond demands uncanny forecasting. Adding to the complexity one must quantify ineffable variables like the real equilibrium short-term interest rate (r*), GDP potential and the non-accelerating inflation rate of unemployment (NAIRU).
New York Fed President William Dudley said his penchant for gradualism “is reinforced by the fact that we do not know with much precision how low the unemployment rate can go without prompting a significant rise in inflation… (T)he U.S. labor market may have more slack than the 4.1% unemployment rate suggests.”
“Whether monetary policy will need to move to a restrictive setting depends crucially on how low the unemployment rate can go without inflation climbing meaningfully above 2%,” the FOMC vice chairman added.
Furthermore, officials must reckon with exigencies about trade, fiscal policy and financial conditions.
All this complexity and uncertainty inclines the FOMC to be discretionary and reactive.
The SEP provides a blurry road map, but does not provide precise GPS directions on where to turn.
As Powell observed in his March 21 press conference, “The projections are really just individual projections that are submitted and then compiled…. Like any set of forecasts, those forecasts will change over time, and they’ll change depending on the way the outlook of the economy changes….It could change up. It could change down. (F)or now, these are the best forecasts that people could make… (I)t could be that if the economy’s a little bit stronger or a little bit weaker, then the path could be a little less gradual or a little more gradual.”
Since the March meeting, it has been reported that GDP growth slowed to 2.3% in the first quarter, after three quarters around 3%. But that wasn’t as weak as feared, and in any case the Fed has gotten used to first period slumps. Recent data on retail sales, housing starts, home sales and industrial production look more encouraging.
Job markets keep tightening. The beige book found spreading worker “shortages” and compensation pressures. Although non-farm payrolls grew a disappointing 103,000 in March, they rose an average 202,000 per month in the first quarter. That’s “roughly twice as many as would be required to keep the unemployment rate stable at current levels of employment, given the growth in the labor force,” Boston Fed President Eric Rosengren noted.
Wage and price increases make officials increasingly confident PCE inflation will soon reach 2%.
Add to the mix the disputed impact of tax cuts and increased federal spending. Evans says “fiscal policy has swung into a strong expansionary gear,” but officials differ on demand and supply side implications.
Financial conditions, after tightening, seem to have stabilized in a still-accommodative mode. The Chicago Fed’s National Financial Conditions Index has been steady at -0.75 since mid-March.
Stocks have regained an unsteady footing. Following a “correction” of more than 12%, the Dow has rebounded erratically.
The yield curve has shifted higher roughly 50 basis points this year, topped by the 10-year Treasury note near 3%. The spread between 10- and 2-year yields has narrowed, but only from 54 to 47 basis points as this was written.
St. Louis Fed President James Bullard fears a flattening yield curve, but others are more sanguine. “I’m not viewing the current flattening of the yield curve as a particular signal towards a pending recession,” Vice Chairman for Supervision Randal Quarles said.
Helping buoy investors, trade frictions have subsided. As proverbial “cooler heads” have prevailed, trade war fears, which Powell called “a more prominent risk to the outlook,” have diminished — not that they’ve disappeared.
The International Monetary Fund boosted its global growth forecast to 3.9%, but at its Spring meeting Powell, U.S. Treasury Secretary Steve Mnuchin and their counterparts declared risks are “skewed to the downside.” The IMF’s advisory committee of finance ministers and central bankers warned “rising financial vulnerabilities, increasing trade and geopolitical tensions” and debt burdens “threaten” growth. Equities have lost their tranquility. The CBOE Volatility Index spiked to more than 24 in March. The VIX has since receded to 16-17, but that’s far above last year. The S&P 500 has had nearly four times as many single-day 1% swings than all of last year,
This worries some officials. Others take it in stride.
Now less dovish Governor Lael Brainard says “asset valuations across a range of markets remain elevated relative to a variety of historical norms, even after taking into account recent market volatility.” Voting Cleveland Fed President Loretta Mester says increased volatility is among “risks to the outlook,” but has “not caused me to change my (‘strong’) outlook for the overall economy.”
“The increased volatility this year has not been associated with signs of financial market stress, such as disorderly trading, a lack of liquidity, or contagion to other markets,” she noted. “And while a deeper and more persistent drop in equity markets could lead to a pullback in risk-taking and spending, the movements we have seen thus far are not close to this scenario.” Business contacts tell her “higher volatility has not deterred planned spending.”
Given all these vectors, policymakers want nothing more than gradual monetary firming.
When he spoke April 6, Powell pledged a “patient approach.” He said “raising rates too slowly would make it necessary for monetary policy to tighten abruptly down the road, which could jeopardize the economic expansion.. But raising rates too quickly would increase the risk that inflation would remain persistently below our 2 percent objective. Our path of gradual rate increases is intended to balance these two risks.”
Dudley concurs: “Even though the unemployment rate is low, inflation remains below our 2% objective. As long as that is true, the case for tightening policy more aggressively does not seem compelling.”
Uncertainty about r* matter too. For now, Dudley estimates the real rate at 1%. Factoring in 2% inflation, “there is still some distance to go before monetary policy actually gets tight.”
Fiscal and trade developments are “likely to increase the uncertainty around the distance to a neutral monetary policy stance and the possibility that the FOMC will have to move to a restrictive stance.…,” warns Dudley. ”By increasing uncertainty around the economic outlook, these shifts in fiscal and trade policy could make it more difficult for the FOMC to achieve its dual mandate objectives.”
Similarly, San Francisco Fed President John Williams, who’ll succeed Dudley June 18, said that since “the economy continues to steam ahead” despite six rate hikes, he is “confident that we can carry on the process of gradually moving interest rates up over the next two years while seeing solid growth and historically low rates of unemployment.”
Brainard is less worried about inflation than about financial stability: “Inflation appears to be well-anchored to the upside around our 2% target, but there are some signs of financial imbalances,” she said, citing “elevated risks” in asset valuations and business leverage.” But she believes countercyclical capital requirements, not monetary tightening, are the way to counter those imbalances.
Atlanta Fed President Raphael Bostic, like Williams a voter, thinks the Fed needs to get the funds rate to neutral, not restrictive. He’s “actually very comfortable going above 2% (inflation) to some amount, 2.2% – 2.3%, I don’t think that is a crisis of overheating necessarily.”
Not even more hawkish officials advocate the kind of aggressive tightening seen in the past.
Mester expects inflation will rise only “gradually” to 2% “on a sustainable basis over the next one to two years.” So “a gradual upward path of interest rates will help sustain the expansion and balance the risks so that our monetary policy goals are met and maintained.”
“We want to give inflation time to move back to goal, and I don’t expect inflation to pick up sharply; this argues against a steep path…,” Mester went on. “A gradual upward path of interest rates should also help to avoid financial imbalances and a potential build-up of financial stability risks that could arise from the extended period of very low interest rates.”
Symmetrically, Mester said “if the upside risks to growth come to pass, we may need to steepen the path a bit; if inflation surprises on the downside, we may need to go a bit slower.”
While the Fed mustn’t “forget the painful lessons of the 1970s and 1980s,” Evans maintains “we are living under different circumstances today…. I think we have the opportunity to more patiently read — and react to — the incoming data…. (W)e can undertake more moderate monetary policy adjustments today…”
By contrast, erstwhile dove Rosengren cautioned “inflation is likely to increase a bit more than the current median forecast by FOMC participants,” and so “more tightening may end up being needed than is currently reflected in the projected median for the federal funds rate.”
The Fed’s path may steepen, but not without considerable persuasion.