Written exclusively for InTouch Capital Markets
5th June 2018
By Steven K. Beckner
Federal Reserve Chairman Jerome Powell and his colleagues will be making monetary policy in what Charles Dickens might have called “the best of times and the worst of times” when they convene a crucial mid-year Federal Open Market Committee meeting June 12.
Amid nearly unparalleled prosperity, an array of downside risks are said to threaten the U.S. economy. Counsels of doom and despair abound.
So, although the FOMC is widely expected to raise short-term interest rates for the second time this year and the seventh time since leaving the zero lower bound, it is a matter of conjecture where rates go from there.
The May employment report provided fresh confirmation that the economic expansion is alive and well. The bigger-than-expected 223,000 non-farm payroll gain far exceeded the minimum needed to absorb new entrants into the labor force. The unemployment rate dropped to an 18-year low 3.8%. And average hourly earnings validated the beige book survey’s anecdotal findings, growing a more rapid 0.3% (2.7% from a year ago).
Unfortunately, this positive domestic news was overshadowed by worrisome international developments, as trade tensions flared anew. Powell got an earful about the Trump administration’s “America First” trade policies when he and Treasury Secretary Steve Mnuchin met with their counterparts from other Group of Seven nations in Canada. As the meeting concluded on June 2 the U.S. was on the brink of a potentially quite damaging trade war with is closest allies.
The U.S. has long been top dog in the G7, but it was odd man out when the leading industrial nations’ finance ministers and central bank chiefs met in Whistler, British Columbia in what was snarkily referred to as a “G6 Plus One.”
On the heels of the U.S. decision to impose steep tariffs on metal imports from Canada, the European Union and Mexico, the meeting was pretty much a shambles. With those countries announcing retaliatory tariffs of their own against U.S. products, the G7 was divided as it’s seldom been. The U.S. was upbraided by the other six after three days of meetings. A communique, written in Ottawa, asked Mnuchin to “communicate their unanimous concern and disappointment” to President Trump. Individual officials had harsher things to say.
The on-again-off-again dispute with China is no less acrimonious.
As if all that wasn’t enough, Italy’s political crisis led to a worldwide market sell-off as George Soros and other more disinterested observers declared the EU and the euro currency zone to be facing an “existential crisis” that could have global financial reverberations.
Not an easy time to be a central banker surely, but fears that monetary policy itself will steer the economy over the edge seem overwrought.
Predictions that the Fed will either overdo it or under-do it on interest rates look rather rash to me. While policy mistakes are always possible, nothing in the FOMC’s recent strategizing seems destined to lead the economy over the precipice. Economic or financial disaster seems more likely to stem from some non-monetary direction.
In pursuit of its primarily domestic goals, Powell’s FOMC is committed to a slow, steady and moderate firming of monetary policy. When there was alarmist talk of aggressive Fed tightening, I consistently warned against expecting such reckless policies, and I stand by that. I don’t foresee a significant steepening of the path of the federal funds rate beyond what has been laid out, given current economic assumptions.
However, I would also caution against going too far in the other direction.
When minutes of the May 1-2 FOMC meeting were released a few weeks ago, there were widespread assertions that “doves” had dominated discussions on the Fed’s rate-setting body — that the Committee had been governed by “dovish” sentiment.
I’ve always been leery of the terms “hawk” and “dove,” Granted, those labels can be convenient at times, but they are relative and changeable. Is Governor Lael Brainard now a “hawk” even though she was slower than just about anyone to support rate hikes over the past several years?
Gratuitous use of the “dove” label is a particular misnomer just now. To be sure, the first quarter slowdown in GDP growth probably inclined policymakers to be a little less rambunctious, but let’s not get carried away.
Powell and the FOMC majority, shifting in composition though it is, have never envisioned the kind of tightening we’ve seen in previous business cycles. The plan all along, as inherited from Janet Yellen, was to “normalize” rates “gradually.” Or, as Powell has said, a “patient approach” is what’s needed.
That has not meaningfully changed.
In March, when the FOMC last went through the exercise of compiling participants’ economic forecasts and funds rate projections, this approach took the form of a funds rate “dot plot” little changed from the one published in December — even though since then major fiscal policy and other changes had made Fed officials and others more optimistic about the outlook.
Although the FOMC lifted rate projections in March, they could hardly be called aggressive. As in December, six participants projected three 2018 rate hikes. Three more anticipated four moves. But 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%, and the median for 2020 rose just three tenths to 3.4% — only modestly “restrictive” compared to an estimated longer run “neutral” rate of 2.9%.
It would be surprising if the rate projections change a lot.
A presumed 25 basis point funds rate hike on June 13, which would take the target range to 1.75% to 2.0%, would leave a six-month window for a third projected rate hike — possibly a fourth if the economy doesn’t stumble and wage-price pressures continue to mount gently.
This doesn’t seem like anything to get upset about. Yet, despite pledges of gradualism both in raising rates and shrinking the balance sheet, we continue to see periodic mini-tantrums in financial markets. Some warn the Fed will raise rates too far and fast and cause a recession. Others fear the Fed will find itself “behind the curve” and have to play catch-up to curb inflation. Then there are those who warn the yield curve will invert and herald recession.
We’ve seen increased volatility in stock prices predicated on such fears. Bond yields have also fluctuated wildly. Less than two weeks after hitting 3.12%, the 10-year Treasury note yield fell as low as 2.76% in late May.
Far be it from me to second guess Wall Street, but it seems overwrought, at least regarding monetary policy. As I read mainstream Fed thinking at this time, there seems to be a fairly confident hope that the economic expansion has another couple of years to run under current assumptions about monetary and financial conditions — that nothing inherent in the macroeconomic picture guarantees a crack-up. It is believed, rightly or wrongly, that the Fed is not steering the economy into the kind of inflationary overheating that has forced the kind of tightening that has doomed other expansions. By the time we get to 2020, officials feel more dubious about the economy’s prospects, but not because of anything the Fed does. The worry is that non-monetary policies could put the brakes on the expansion.
While monetary miscalculations could conceivably cause contraction, fiscal or trade policy or some geopolitical shock are more likely culprits. The FOMC is aware its cautiously optimistic outlook is subject to such downside risks.
As it has long promised, the FOMC will take into account “financial and international developments” in determining “the timing and size of future adjustments” to the federal funds rate. Such developments caused the FOMC to delay and moderate funds rate hikes in 2015 and 2016.
Such developments could again cause the FOMC to proceed more cautiously. There doesn’t seem to be any sense of urgency about monetary tightening that would preclude that.
At the same time, policymakers are unlikely to assume the worst. It must be borne in mind that the imposition of tariffs against U.S. trading partners may well not be the end of the story. As Trump economic advisor Lawrence Kudlow has emphasized, it’s a step in a negotiation process.
Following the G7 meeting, Kudlow said the Trump administration is determined to make trade more “fair” and “reciprocal” but dismissed the dispute with Canada and the EU as “a family quarrel” that “can be resolved if we work together.” He said “everything is on the table.”
Meanwhile, as Kudlow said, “the economy is booming,” and one consequence is dollar appreciation that could increase the trade deficit and limit GDP growth despite Trump’s efforts to narrow it — something else the FOMC will have to weigh in making its forecasts and projections.
Assuming the FOMC does raise the funds rate, there will likely be a new twist.
Past 25 basis point funds rate hikes have been accompanied by a like increase in the discount rate and in the interest rate on excess reserves (IOER) to the top of the new funds rate target range. But at the May meeting, minutes revealed, the FOMC was advised by the New York Fed to make “a small technical adjustment” and raise the IOER 20 basis points to leave it five basis points below the top of the target range.
The minutes say “many participants” thought it would be “useful to make such a technical adjustment sooner than later.” And “participants generally agreed that it would be desirable to make that adjustment at a time when the FOMC decided to increase the target range for the federal funds rate,” i.e. presumably on June 13.
The minutes add that “while additional technical adjustments in the IOER rate could become necessary over time, these were not expected to be frequent.” I take that to mean this will be a one-time adjustment, at least until next year.
A more lasting change in communications is coming, but whether we get it at the upcoming meeting is unclear.
The May minutes say “participants commented on how the Committee’s communications in its post-meeting statement might need to be revised in coming meetings if the economy evolved broadly as expected.”
Since leaving the zero lower bound, the FOMC has said the funds rate was “likely to remain, for some time, below levels that are expected to prevail in the longer run.” However, at the May meeting, “a few participants noted that if increases in the target range for the federal funds rate continued, the federal funds rate could be at or above their estimates of its longer-run normal level before too long.” And “a few observed that the neutral level of the federal funds rate might currently be lower than their estimates of its longer-run level.”
So the minutes say “some” officials thought “it might soon be appropriate to revise the forward-guidance language.”
After six rate hikes, the FOMC reiterated in May that monetary policy “remains accommodative,” but some think that language also needs to go.
Powell’s own communications, at his second post-FOMC press conference, can go a long way toward reassuring markets and modulating financial conditions.