Written exclusively for InTouch Capital Markets
20th September 2018
By Steven K. Beckner
Federal Reserve Chairman Jerome Powell should have no trouble getting support for an increase in the federal funds rate at the Federal Open Market Committee’s late September meeting — what would be the third since he took over from Janet Yellen in February and the eighth since the FOMC stopped holding rates near zero in December 2015.
A fourth hike seems likely in December, which would take the policy rate’s target range to 2.25-2.5%.
With the presumed September increase, the FOMC could decide to drop or perhaps amend past assertions that “monetary policy remains accommodative.”
The larger question is how many more funds rate increases Powell and his colleagues will tentatively plan when they reconsider their projections in their quarterly Summary of Economic Projections (SEP).
In their June “dot plot,” FOMC participants projected three moves in 2019, taking the funds rate up to a 3.0-3.25% range (median 3.1%), and another in 2020 to a 3.25-3.50% range (median 3.4%).
Will they revise their dots higher in light of rapid economic growth and tightening labor markets? Or will they stay with their June projections out of caution about downside risks and lingering uncertainty about the persistence of 2% inflation?
The strong thrust of recent data and the long awaited escalation of inflation have made it relatively easy thus far for Powell to make the case for rate “normalization.” Outside a few vocal dissenters, a consensus for monetary firming hasn’t been hard to build.
Raising rates could get tougher next year, after the remaining 2018 moves bring the funds rate closer to putative “neutral.” Debate is raging over just where neutral lies, where it’s headed and whether to go beyond it.
For now, though, the course seems clear. The bulk of the data all but guarantee a 25 basis point increase in the funds rate to 2-2.25% on Sept. 26, with the odds favoring another rise on Dec. 19.
The U.S. economy has been on a tear. After growing by 4.2% in the second quarter, real GDP is expected to grow 3% or more in the third quarter. The Atlanta Fed recently lifted its GDPNow estimate of third quarter growth to 4.4%. Those dismissing the economy’s renewed dynamism have been proven wrong.
The Institute for Supply Management’s manufacturing index hit a 14-year high last month.
Retail sales grew a disappointing 0.1% in August due to weak motor vehicles purchases, but July sales were revised higher, and it seems doubtful consumer spending has lapsed into lasting softness. The beige book survey found that “consumer spending continued to grow at a modest pace” through Aug. 31.
The labor market continues to tighten, and this is finally generating larger wage gains. In August, non-farm payrolls rose a greater than expected 201,000 — well over what’s needed to absorb new entrants to the labor force. The U-3 unemployment rate stayed at 3.9%, but the broader U-6 rate fell to a seven-year low 7.4%. Average hourly earnings rose 0.4%, leaving them up 2.9% from a year ago — best in more than nine years.
The fiscal stimulus of tax cuts and increased federal spending is coming on stream. Just as important is the Trump administration’s deregulatory efforts. Financial conditions are also supportive. Optimism about growth and corporate earnings and hope for a resolution of trade tensions propel stocks higher, while longer term market interest rates remain modest — the 10-year Treasury note yield still below 3%.
Against that backdrop, at least some FOMC participants may well recommend a steeper rate path. Already in June, four officials favored four or more rate hikes next year. That number could grow.
Other officials are sure to make counterarguments. President Trump’s nerve rattling efforts to make “fairer” trade deals with China, Europe, Canada and Mexico pose downside risks. Dollar appreciation has aggravated the economic and financial woes of emerging market nations.
And just when Fed policymakers were congratulating themselves on finally getting inflation to target, the “doves” can point to recent signs of slippage in inflation after the consumer price index rose a less than expected 0.2% in August overall and 0.1% on a core basis. That brought the year-over-year rises down two tenths to 2.7% and 2.2% respectively.
Upside and downside risks may largely offset, leaving little change in the funds rate dots.
There was a time when the recent economic picture would have the Fed raising rates energetically, but Powell has signaled he wants a cautious approach. Certainly that was his message when he keynoted the Kansas City Fed’s annual Jackson Hole symposium on Aug. 24.
Powell favorably cited former Chairman Alan Greenspan’s “risk management” approach of “waiting one more meeting” for signs of inflation before raising rates in the late nineties. And he cited economist William Brainard’s principle that “when you are uncertain about the effects of your actions, you should move conservatively.”
Reiterating his desire to raise rates neither too quickly nor too slowly, he commended the “current path of gradually raising interest rates as the FOMC’s approach to taking seriously both of these risks.”
Powell advocated a healthy agnosticism about trying to “navigate” by conventional economic “stars.”
“While the unemployment rate is below the Committee’s estimate of the longer-run natural rate, estimates of this rate are quite uncertain,” he said. “The same is true of estimates of the neutral interest rate….We are also aware that, over time, inflation has become much less responsive to changes in resource utilization.”
“While inflation has recently moved up near 2%, we have seen no clear sign of an acceleration above 2%, and there does not seem to be an elevated risk of overheating,” Powell added.
More recent comments by other policymakers have supported moderate further monetary firming.
Governor Lael Brainard, once a leading dove, now says, “Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective.”
She allowed for more rapid hikes on Sept. 12: “While the information available to us today suggests that a gradual path is appropriate, we would not hesitate to act decisively if circumstances were to change. If, for example, underlying inflation were to move abruptly and unexpectedly higher, it might be appropriate to depart from the gradual path. Stable inflation expectations is one of the key achievements of central banks in the past several decades, and we would defend it vigorously.”
Atlanta Fed President Raphael Bostic, who turned a tad dovish after voting for the March and June rate hikes, sounded more eager to raise rates on Sept. 13. “The unemployment rate is low relative to historical standards and has been at or below 4 percent since the spring,” he said. “You’d have to go back nearly 20 years to find a similar performance. This suggests we are at, or at least very close to, full employment.”
“When the economy is doing well and standing on its own, as it is now, I think monetary policy ought to be moving toward a neutral stance,” Bostic said. “For me, this means a gradual increase in nominal interest rates over the next handful of quarters.”
Chicago Fed President Charles Evans, who will be voting next year, seemed to favor moving the funds rate at least as high as projected in June. Assuming the neutral federal funds rate is in a 2.5-3.0% range, “this means that the 3 to 3-1/2 percent level of the funds rate projected for 2019 and 2020 is mildly restrictive,” he said Sept. 14. “Given an unemployment rate forecast below the natural rate, such a policy stance would be quite normal and consistent with some moderation in growth and a gradual return of employment to its longer-run sustainable level.”
Boston Fed President Eric Rosengren, another 2019 voter once considered a dove, recently said, “If things work out well for the economy, and that’s what I expect and hope, then we’ll be in a situation where we need to have somewhat restrictive policy over time.”
At this and subsequent meetings, choosing the way forward will be complicated by divisions and uncertainties over where the real equilibrium short-term interest rate (r*) and in turn the nominal neutral funds rate lie.
In June, the FOMC estimated the longer run funds rate, which includes the 2% inflation target plus a real component, at 2.9%. That’s 135 basis points lower than 4.25% in January 2012. Estimates ratcheted lower as officials became increasingly convinced r* had fallen as slower productivity and labor force growth undermined the economy’s potential for expansion.
What matters is not just the longer run neutral rate but the current neutral rate.
Some still think the real rate is close to zero or a little higher, which would mean the nominal neutral rate is now close to the top of the current funds rate range of 1.75% to 2.0%.
Many hope the real rate and in turn the neutral funds rate will rise if business investment boosts productivity growth and GDP potential, but expectations vary. And no one really knows.
Brainard highlighted the importance of the neutral rate in setting the actual funds rate, focusing first on the “shorter-run neutral rate,” which she said “fluctuates along with important changes in economic conditions,” such as tax cuts that can “generate tailwinds to domestic demand” and changes in risk appetite.
She said “monetary policy can help keep the economy on its sustainable path at full employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate.”
The longer run neutral funds rate is what the FOMC publishes, but “the shorter-run neutral rate, rather than the longer-run federal funds rate, is the relevant benchmark for assessing the near-term path of monetary policy in the presence of headwinds or tailwinds.”
The fact that unemployment has returned to pre-crisis levels and job gains have increased despite rising rates suggests “the short-run neutral interest rate likely has also increased…,” Brainard contended. “This is also suggested by the observation that overall financial conditions … have remained quite accommodative during a period when the federal funds rate has been moving higher.
In June, FOMC participants projected that at the end of 2020, the median funds rate will exceed the longer run neutral rate by 50 basis points. Brainard thinks that’s entirely appropriate.
“With government stimulus in the pipeline providing tailwinds to demand over the next two years, it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher than the longer-run neutral rate. Further out, the policy path will depend on how the economy evolves.”
“These developments raise the prospect that, at some point, the Committee’s setting of the federal funds rate will exceed current estimates of the longer-run federal funds rate,” she added.
This might mean the already flat yield curve inverts. That bothers some officials more than others, but that prospect undoubtedly provides another reason to proceed cautiously.
It’s doubtful the FOMC will stray far from Powell’s cautious middle course, unless inflation diverges significantly from expectations.
The economic forecasts in the new SEP will bear watching. in June, the median forecast for real GDP growth (fourth quarter over fourth quarter) was 2.8% in 2018; 2.4% in 2019 and 2.0% in 2020. That was relative to a longer run estimate of 1.8%.
Unemployment was seen at 3.6% in 2018 and 3.5% in each of the following years. PCE inflation was forecast to rise to 2.1% next year and 2020.
It seems likely the near-term GDP forecast will rise, but not much, because of doubt whether Trump policies will have a lasting impact. If the longer run GDP growth estimate is raised from 1.8% we might also see an uptick in the longer run funds rate estimate.
The composition of the FOMC keeps changing. The San Francisco Fed tapped its director of research Mary Daly as its new president, succeeding John Williams, who left in July to lead the New York Fed. She will vote in November and December after taking office Oct. 1. Richard Clarida was sworn in as Vice Chairman Sept. 17 and will participate in the upcoming meeting.
Clarida has somewhat of a hawkish reputation, although after the crisis, he backed unconventional easing. In current circumstances, he’s likely to be a centrist supporting continued rate hikes in league with Powell and Williams.
Daly is more of an unknown quantity. She has said the economy is at full employment and that monetary policy needs to be conducted to sustain the expansion, but beyond that her leanings are unclear.
On the quantitative side of policy, shrinking the Fed’s balance sheet has been proceeding as designed. Bond rollovers and reinvestments have not reached the maximum level planned, but it wouldn’t be surprising if the Committee discusses when to halt the resulting reduction of reserve balances.
Since last October, the Fed has slashed holdings of Treasury and agency mortgage backed securities by rolling over or reinvesting principal maturities only to the extent they exceed gradually increasing caps. As scheduled, the caps have risen each quarter by $6 billion per month for Treasuries and $4 billion for MBS. In the third quarter, the caps rose to $24 billion for Treasuries and $16 billion for agency MBS. The total cap will rise from $40 billion to a maximum $50 billion in the fourth quarter.
Then, the FOMC says “the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”
Shrinking the portfolio reduces reserves, of course, and the FOMC “anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future.”
Most officials want to keep a much larger amount of reserves than prevailed before the crisis and continue using interest on excess reserves and overnight repurchase agreements to control the funds rate rather than go to back to pegging the funds rate through open market operations with limited reserves. But that has not been finally determined, and at some point the FOMC will need to decide what its operating framework will be.
At the last FOMC meeting, the minutes say a couple of participants “judged that it would be important for the Committee to resume its discussion of operating frameworks before too long” and said “the Chairman suggested that the Committee would likely resume a discussion of operating frameworks in the Fall.”