Written exclusively for InTouch Capital Markets
14th March 2018
By Steven K. Beckner
U.S. monetary policy is transitioning, but at this stage the interest rate outlook is neither as slow and gradualist as it once was nor as rapid and aggressive as some fear it will become.
Federal Reserve policymakers will compile their first set of economic and rate projections of 2018 when they gather for their second Federal Open Market Committee meeting of the year March 20-21, and what once seemed like a certain occasion for more ambitious forecasts and more aggressive rate hikes is looking more nebulous.
Another quarter point hike in the federal funds rate to a range of 1.50% to 1.75% is all but sure to be announced on March 21, but far less certain is the number of rate hikes which FOMC participants will anticipate for the rest of this year and beyond.
The Fed is operating in one of the trickiest policy environments ever. New Chairman Jerome Powell & Co. were already having to contemplate the combined stimulative effects of massive tax cuts and budget-busting federal spending, not to mention deregulation. Now, in wake of President Trump’s decision to impose stiff tariffs on aluminum and steel, they must confront contrary forces.
At the very least, higher tariffs present the prospect of artificially generated cost pressures. At worst, they could bring about an economically debilitating international trade war.
Trump has softened the blow somewhat by making exceptions for Canada, Mexico and others, but his still-evolving “America First” strategy will remain a complicating factor for forecasters and policymakers alike.
In such a complex and uncertain environment the Fed’s inclination has always been to proceed cautiously, and I suspect that’s what we’ll see on March 21, when the FOMC releases its policy statement and Summary of Economic Projections and when Powell holds his first post-FOMC press conference since succeeding Janet Yellen last month.
There could be some upward adjustments in the SEP but nothing dramatic.
Powell will have a challenging task in explaining the Fed’s policy stance to reporters. But the unflappable former investment banker seems up to the job after performing well in two days of testimony on the semiannual Monetary Policy Report to Congress.
Much has been made of the combined economic impact of $1.5 trillion in tax cuts and $400 billion of increased federal spending, but that fiscal stimulus could be at least partially offset by higher tariffs, which ultimately amount to a tax on American consumers and businesses.
Atlanta Fed President Raphael Bostic, one of this year’s voting presidents, raised that very possibility on March 7: Whereas increased growth projections due to fiscal stimulus were “forcing us to more aggressive policy,” he said, “the trade stuff is uncertainty in the other direction. And what I don’t have a good sense of is, if you did an accounting, how much the upside uncertainty is fully offset by the trade uncertainty, or does it overshoot such that we might want to revise our forecast downward.”
Trump’s latest protectionist onslaught, which prompted the resignation of his top economic advisor Gary Cohn and roiled markets worldwide, has served to tighten U.S. financial conditions. The Dow lost all its gains for the year after the March 1 tariff announcements.
The market subsequently recovered as Trump softened his tariff plans, but the Dow is still more than 1400 points below its peak as this was written.
Asset levels aside, the sheer increase in volatility may make the FOMC more wary.
Now, policymakers expected a certain amount of financial market tightening. Indeed, they were disappointed that, for example, bond yields had not risen more than they had. In the minds of some that alone warranted a more vigorous monetary response.
But a bear market, which some analysts claim we’ve entered, is another matter.
Less favorable financial conditions lessen the amount of firming the Fed needs to do for now.
What’s more, despite projections of accelerating economic growth, some of the recent data have been disappointing. After three quarters in which GDP grew at an average 3% pace, analysts are expecting growth of less than 2% due to slower consumer spending.
Even the stronger than expected February employment report, with its 313,000 jump in non-farm payrolls and 800,000 increase in labor force participation, had its softer side. Average hourly earnings, which had risen at a year-over-year 2.9% pace in January, slipped to 2.6% rate last month.
That underscored the fact that inflation remains imponderably subdued.
As the unexceptional Beige Book survey conducted for the upcoming FOMC meeting put it, “in many Districts, wage growth picked up to a moderate pace.”
Price pressures also remain muted. Relative to its 2% target, the Fed’s preferred price index for personal consumption expenditures (PCE) was up 1.7% year-over-year in January. The core PCE was up just 1.5%.
The Beige Book said, “most reports noted moderate inflation.”
None of this means monetary normalization is about to grind to a halt or “pause.” For one thing, the Fed is well aware of the long-established pattern of transitory first quarter GDP swoons, and there seems to be a consensus that GDP growth will trend higher.
But these factors do mean it may be a little early for the FOMC to shift into a higher gear. They lessen the sense of urgency.
The FOMC has the luxury of waiting until closer to mid-year to make a more confident assessment of the economic outlook that might justify more aggressive policy firming.
Now, policymakers’ views are not monolithic. Some are more eager to raise rates than others.
Granted, there has been discernible movement in a somewhat more “hawkish” direction, witness recent comments by erstwhile “dove” Governor Lael Brainard. New York Fed President William Dudley has also been sounding a bit more hawkish.
The new Fed theme these days is that erstwhile economic “headwinds” are transmuting into “tailwinds.” Powell used that metaphor in his Feb. 27 and March 1 Congressional appearances. Brainard chimed in the following week: “Many of the forces that acted as headwinds to U.S. growth and weighed on policy in previous years are generating tailwinds currently.”
What comes through in recent remarks by these and other officials is that the perceived balance of risks is in the process of tipping toward asymmetry. For some time, the FOMC has characterized the risks to the economic outlook as “roughly balanced.” That may be on the verge of changing. Whether we get a less symmetrical statement on March 21 is a close call, though.
Inflation, or the lack thereof remains the chief issue. A division persists between, on the one hand, those who have enough faith in the Phillips Curve trade-off between tight labor markets and inflation to want to be somewhat preemptive on the one hand and, on the other hand, those who want to see more evidence of wage-price pressures.
Exemplifying the latter, Chicago Federal Reserve Bank President Charles Evans said on March 9 his “own preference would be to wait a little bit longer” and “let the March anomalous inflation rate from a year ago fall out” before supporting what would be the sixth rate hike since the FOMC left the zero lower bound in December 2015.
But let’s be careful not to exaggerate these two positions. Even the more preemptive-minded are not ready to move away from the gradual approach.
I don’t think either Powell or Brainard were signaling a much more aggressive Fed posture.
True, Powell said the data “suggests strengthening in the economy” since the FOMC projected three 2018 rate hikes in December, and he said some of the data “add some confidence to my view that inflation is moving up to target.” But he was careful to note that “inflation remains below our 2% longer-run objective” and that, hence, “further gradual increases in the federal funds rate will best promote attainment of both of our objectives.”
Brainard is no longer opposing rate hikes or urging the Fed to go slow, but she has not changed her feathers that much. She has merely become more mainstream with her assertion that “continued gradual increases in the federal funds rate are likely to remain appropriate to ensure inflation rises sustainably to our target and to sustain full employment, keeping in mind that interest rate normalization is well under way and balance sheet runoff is set to reach its steady-state pace later this year.”
She added that the FOMC “should be ready to adjust the path of policy in either direction if developments turn out differently than expected.”
Of course, the meaning of “gradual” is subject to change. Certainly last year’s three 25 basis point rate hikes constituted a “gradual” pace, though not as gradual as in the prior two years, but as Dudley observed on March 6, four rate hikes — one per quarter — “would still be gradual.”
This is a time of flux for the economy and hence for monetary policy.
And so, as Powell advised, don’t “prejudge” the outcome. Although markets would be astonished if the FOMC does not move the funds rate up another notch on March 21, nothing is locked in beyond that point.
The economy’s prospective growth trajectory may have turned up, but so has uncertainty. As the Monetary Policy Report observed, uncertainty about projections for GDP growth, unemployment and inflation, “is substantial and generally increases as the forecast horizon lengthens.” In December, it said, about half of FOMC participants felt that uncertainties about tax legislation had “raised their assessment of uncertainty for GDP growth.” No doubt the tariff controversy, with its manifold effects on financial markets and foreign government policies, has further increased uncertainty.
Fed Vice Chairman for Supervision Governor Randal Quarles also emphasized the elements of “increased uncertainty and precaution” late last month in explaining why the economy has been so sluggish until recently before saying it now “appears to be performing very well” and is “in the best shape that it has been in since the crisis and.”
He too “anticipate(d) further gradual increases in the policy rate will be appropriate to both sustain a healthy labor market and stabilize inflation around our 2 percent objective.”
Added uncertainty about trade, increased volatility in financial markets and doubts about the GDP growth pace so far this year will tend to reinforce this mood of gradualism.
Not surprisingly, Fed officials weren’t pleased with Trump’s protectionist measures. The day of the tariff announcement, Dudley said their longer run effects would “almost certainly be destructive.”
Minneapolis Fed president Neel Kashkari was “nervous that there will be economic cost to the U.S. economy in trying to show that the threat is credible.”
What’s good for the metals industry may not be so good for other parts of the economy. It remains to be seen, but to the extent tariffs go up, they seem likely to be more contractionary than inflationary.
In monetary theory an increase in the price of one commodity cannot by itself generate inflation — unless the central banks accommodates it.
Although a rise in one input cost can reverberate through the chain of production and lead to higher prices for other goods and services, it does not necessarily lead to an increase in the aggregate price level. Given a certain amount of money in the economy a change in relative prices merely causes a reallocation of resources among available goods.
Such an increase can only be inflationary if the central bank accommodates the shift in relative prices by expanding the supply of money and credit.
The Fed is not about to become more accommodative, although it could be argued that it’s still “quite accommodative” as Kansas City Fed president Esther George says, and if it stays relatively accommodative by continuing to hold rates below neutral to prevent tariffs from exerting a drag on the economy, arguably a chain reaction of price hikes set off by the increased cost of steel and aluminum could be marginally inflationary.
But not every company or product or contract to build will be able to absorb a sudden jump in the cost of a key raw material or just be able to pass it along to the consumer. And of course the cost of a host of other goods could rise if U.S. trade partners retaliate. So there could be some loss of output even if at the same time there are simultaneous inflation pressures.
Some have blamed the 1970s run-up in inflation on OPEC-engineered price increases, but others maintain it was really the Fed’s accommodation of those higher prices that were to blame.
One thing is for sure: The tariff increases are a complication the Fed would rather not have to deal with.
Well again, none of this is to say we won’t end up getting more rate hikes this year than last — just that it may take a while for FOMC members to become certain enough or confident enough to make up their minds about that — perhaps until the June 12-13 FOMC meeting, when another SEP and another press conference are scheduled.