– Move Cautiously to Neutral, But Not Beyond
– Fed Should Avoid Flattening Yield Curve If It Can
– No Rush Given Inflation Not Out of Control
– Slight Inflation Overshoot “Highly Appropriate”
– Fed Could Exceed Neutral Rate Unintentionally
– Tight Labor May Constrain GDP, Generate Inflation
– Sustained Tariff Increases Would Push Up Prices
– Lot of Pent-up Pressure To Raise Prices
Written exclusively for InTouch Capital Markets
28th June 2018 (Released 2nd July)
By Steven K. Beckner
The Federal Reserve tilted toward a modestly more aggressive monetary policy approach at its mid-June meeting, but one centrist Federal Reserve Bank President is standing fast and urging “caution,”
Philadelphia Fed President Patrick Harker is not ordinarily thought of as a “dove,” but he made a strong case for going slow on further rate hikes in a June 27 interview.
Harker favors moving the funds rate setting to “neutral” over the next couple of years, but not beyond it into restrictive territory. Not only is there little danger of inflation or financial imbalances, he told me, the Fed should be wary of flattening and perhaps eventually inverting the yield curve.
Though he shares Chairman Jerome Powell’s skepticism about the yield curve as a predictor of recession, his basic argument is: why tempt fate and fuel market fears on that score.
Harker also told me he sees “downside risks” from the Trump administration’s trade policy.
What makes Harker’s comments compelling is that he’s not a doctrinaire “dove,” having voted for all three 2017 rate hikes. He will be a voter again in 2020, when the crucial decisions are likely to be made on whether or not to take policy beyond neutral.
In raising the funds rate on June 13 for the second time this year (the seventh time since leaving the zero lower bound) to a target range of 1.75% to 2.0%, a majority of FOMC participants boosted their rate projections. They now foresee two more rate hikes this year for a total of four, one more than in March.
They look for three more rate hikes in 2019 and one more in 2020, bringing the median funds rate to 3.4%. — the same as in March but up from 3.1% in December.
Harker did not join the march toward an incrementally tighter policy.
One big reason is vestigial doubt about sustaining inflation at the Fed’s 2% target: “I think we’re moving toward that, but that’s why I still have three increases this year – -one more increase.”
“I would be willing to go to a second increase if we saw inflation accelerate,” Harker said. “That evidence is not there yet, but I’m open-minded.”
“I think it’s possible we can sustain 2%,” he continued. “It looks likely we’ll be able to do that, but as a policymaker I want to be cautious, particularly because of the other issue I’m sure you’re going to bring up — the yield curve.”
Harker had heard me ask Powell about that very subject following the FOMC meeting, and he made clear it is a key issue for him.
In his response to me, Powell had said reduced term premiums help explain why the long end of the yield curve has failed to ratchet up with short rates and said this may mean the flatter yield curve has “less of a signal.”
Harker also cited term premiums, but emphasized, “I’m a pragmatist. So the question is — and there’s a lot of debate about it — does the yield curve portend a recession or not? There is clear evidence that there is correlation, but that doesn’t mean causality.”
Nevertheless, he said research shows “there is clearly a reason to be concerned. And so, as a pragmatist my view is if we can avoid it, let’s avoid it.”
Besides, Harker went on, “there seems to be no rush to raise rates because inflation is running out of control. So let’s take our time, and if we can avoid any flattening of the yield curve I think that’s a good policy to pursue.”
Even if the yield curve is a less reliable predictor of recession than in the past, if enough people believe it is a less reliable predictor that matters to Harker. “Expectations in financial markets are always important.”
And so, he reiterated, “if we can avoid a further flattening of the yield curve that is a prudent thing to do. And right now, my judgment is we can do that — that there’s no rush to rapidly increase the short end of the curve — the federal funds rate.”
Far from being concerned about inflation topping 2%, “a slight overshoot would be highly appropriate,” he said.
The FOMC’s 3.4% median projection for the end of 2020 would put the funds rate five tenths above the estimated longer run “neutral” rate of 2.9%, implying some degree of restriction.
Taking issue, Harker said, “that’s not where I am. I see us moving to a rate of 3, possibly 3 1/4, before coming back down to a 3% neutral rate.”
“I don’t want to overshoot the neutral rate by much, if at all,” he added.
When I asked him what might justify making policy restrictive, Harker replied, “I would like to avoid that.”
“It may happen because we can’t perfectly estimate what the neutral rate is,” he granted. “It’s a latent variable in our thinking, in our model, so it’s something we won’t know until we reach it, and it’s possible there will be a slight overshoot, but personally I’d like to avoid that.”
If the neutral rate, which is made up of the inflation target plus a real component (r*), were to rise, the Fed could conceivably have more room to raise the funds rate without becoming restrictive. But Harker said a higher real rate largely depends on faster productivity growth, and “there’s not a lot of evidence that that’s occurring.”
Just as there is uncertainty about exactly where the neutral rate is, the Fed is bedeviled by uncertainty about the “natural” unemployment rate, or non-accelerating inflation rate of unemployment (NAIRU). The FOMC’s current estimate of the longer run unemployment rate is 4.5%, but the actual unemployment rate has fallen to 3.8%, and FOMC participants project it will fall to 3.5% by the end of next year.
The undershooting of NAIRU doesn’t bother some Fed officials, who point out that wage growth remains slow. But for Harker “it is a concern in a couple of ways.”
First, it does pose an inflation risk. Although the old Phillips Curve trade-off between unemployment and inflation has been rendered practically “nonexistent” by low inflation expectations, the Fed cannot ignore the implications of very low unemployment for wages and in turn prices, in Harker’s view.
“We do have to, though, think that at some point when labor markets get as tight as they’re getting you’re going to see wage pressures move through the economy to create inflation,” he told me.
“It’s inevitable, and the anecdotes are now building up to the point where they’re no longer just random anecdotes,” he said. “The labor markets are really tight…”
From employers in his third Fed district, Harker is hearing mounting concerns that “they cannot find the people they need.”
Though wage growth so far remains modest, he said “we are starting to see acceleration of wages” at the low and high skill ends of the labor market.
So, Harker said “inflation is one of the issues we need to focus on because it will eventually move its way through, which is why I’m for prudently moving to a neutral stance. There’s no rush to do it, but when we get a chance to do it we should.”
Harker’s second cause for concern about tight labor markets is that worker shortages could increasingly constrain the economy’s ability to expand.
“What we’re seeing now is that firms all across the spectrum are desperately looking for workers,” he said, noting that job openings now exceed job seekers. “This is not a normal circumstance in our economy.”
“What I’m worried about is not so much inflation — I think we can keep that under control — it is that if we don’t have the workforce we need we won’t maintain the economic growth we’ve come to expect.”
Harker is seeing shortages of workers everywhere from agriculture to manufacturing to service industries to health care to construction.
“Now, it hasn’t yet translated into wage pressure we’d come to expect, but we’re starting to hear people not only looking for mid-year increases in prices for their goods, but mid-year increases in salaries to retain their workers.”
Another potential source of price pressure is tariffs, Harker warns.
He has not yet trimmed his economic forecasts while the outcome of trade negotiations remains in doubt, but he’s wary about how higher tariffs might affect his industrialized district. “Until we get more clarity on that issue I’m not willing to make any changes, but it is something we’re noting as a downside risk….”
“The question of course is, if the tariffs are on for a while, what flows through to the end consumer over a period of time?” he asked.
“That’s still debatable, but if there’s a big, sustained set of broad-based tariffs I think it’s inevitable you’d see prices rise.”
As an example of the kind of pressures that are brewing, Harker cited a business contact in his district who told him a foreign supplier announced “I’m going to give you a 10% increase because of aluminum tariffs.” When the U.S. contact told the supplier, “this is a final product, not raw aluminum; you’re not subject to those tariffs,” he was told, “I know, but I might be. That’s why I’m asking for it now.”
Harker said “there is a lot of pent-up pressure that we’re feeling — that people have been unable to raise prices for a long period of time through the recovery. So we’re hearing from different contacts that they’re considering for the first time in a long time price increases.”
Some of his colleagues have warned that holding rates down too long could generate financial risks and imbalances even if it doesn’t cause inflation, and Harker said he “shares(s) some of that concern in terms of being alert to those issues and watchful.”
Harker said he doesn’t “see any bubble” at this time, but said avoiding that is another reason to “move rates prudently to neutral.” But again, he said that means just three rate hikes this year and next, not more.
In raising rates, Harker said the Fed must be mindful that “if the yield curve becomes flatter that does put pressure on banks, particularly smaller banks.”
Increased financial market volatility also bothers Harker: “I think the volatility is a symptom of a deeper issue, which is maintaining the confidence of the consumer and business to buy, to invest….”
If volatility is a function of uncertainty that’s not a good sign…,” he said. “It’s very difficult to make decisions in that environment.”
The FOMC deleted from its June 13 policy statement the previous assertion that “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” It continued to say “the stance of monetary policy remains accommodative.”
Harker said it was “appropriate” to “recognize that we are approaching neutral.” He sees no near-term need to further change FOMC forward guidance, for instance, to stop calling policy “accommodative,” but said, “I think it’s pretty clear we are moving to that neutral stance within in the next year or year and a half or two. At that point we should recognize that in our statement, and I think we will eventually.”