Written exclusively for InTouch Capital Markets
27th July 2018
By Steven K. Beckner
Although the U.S. economy has seldom looked better, Federal Reserve Chairman Jeremy Powell and his colleagues will make monetary policy under a couple of clouds when they convene their July 31-Aug. 1 Federal Open Market Committee meeting.
One cloud which has been billowing for months and grown more ominous is the gathering storm of trade tensions.
A more recently emerging nimbus has loosed a downpour of White House political pressure on the Fed.
Also casting a shadow on an otherwise sunny landscape as the Fed has “normalized” interest rates is the worrisome shape of the yield curve.
It all makes for a complicated policymaking environment as we move into the second half, but none of these issues hanging over the Fed will likely affect the outcome of the upcoming meeting.
Having just raised the federal funds rate 25 basis points in June to a target range of 1.75% to 2.0%, the FOMC is not apt to take further action just yet. Besides, it would be surprising to get a move at a meeting featuring neither a Powell press conference nor a revised set of economic and rate projections. Expectations could change when Powell starts holding a press conference after every meeting, but that won’t begin until next year.
Nevertheless, this meeting will be important, helping set the tone for subsequent rate decisions. There is sure to be vigorous discussion and debate between officials who think the Fed needs to keep steadily lifting rates and those who question how much higher they need to go.
While unanimously raising the funds rate June 13 for the second time this year and the seventh since leaving the zero lower bound in December 2015, the FOMC released sharply divided rate projections. Seven foresaw two more rate hikes this year, while five could justify only one, and two wanted none.
While trade worries were festering then, FOMC minutes suggest the predominant concern was about potential “overheating” as above-trend economic growth tightens labor markets.
A month and a half later, the FOMC will still view a pretty rosy picture. The Atlanta Federal Reserve Bank estimates second quarter annualized growth of 4.5% following first quarter growth of 2.0%. Some forecasters have even higher estimates. FOMC participants project 2.8% real GDP growth for the year (fourth quarter over fourth quarter) — a full point above the estimated “longer run” pace.
Retail sales show vital consumer spending, rose a robust 0.5% in June. The Institute for Supply Management’s manufacturing index, always closely watched at the Fed, leaped unexpectedly from 58.7 to 60.2 that month.
Monetary policy, by most reckoning, remains supportive of growth as do overall financial conditions. Fiscal policy is seen giving the economy a further boost for a while. “We have put in a slight uptick in our GDP estimate with the fiscal stimulus, but that will tail off over the next couple of years to what we’d consider trend growth rates,” Philadelphia Fed President Patrick Harker told me in late June.
The labor market looks impressive. Although the unemployment rate ticked up two tenths to 4.0% in June, that was due to an increase in labor force participation to 62.9% as strong labor demand draws discouraged workers back into the labor force.
Non-farm payroll gains averaged 215,000 per month in the first half — “a good deal higher than the average number of people who enter the work force each month on net,” as Powell noted in his July 17 testimony on the Fed’s Monetary Policy Report to Congress.
Wage gains have remained modest, but June’s 2.7% year-over-year rise in average hourly earnings is faster than in previous years, and there are widespread reports of labor shortages forcing firms to pay more to attract personnel.
As Harker told me, “We do have to 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. It’s inevitable, and the anecdotes are now building up to the point where they’re no longer just random anecdotes….”
The beige book survey conducted for the upcoming FOMC meeting found “firms were adding work hours, strengthening retention efforts, partnering with local schools, and converting temporary workers to permanent, as well as raising compensation to attract and retain employees….”
There is considerable skepticism about the old Phillips Curve theory that falling unemployment leads to higher prices, but certainly policymakers are pleased inflation is finally running at or above its 2% target.
Calling the data “encouraging,” Powell noted the price index for personal consumption expenditures increased 2.3% over the 12 months ending in May, while the core PCE rose 2.0% — compared to 1.5% a year ago.
St. Louis Fed executive vice president Christopher Waller, top policy advisor to that Bank’s president James Bullard, expressed confidence that inflation will stay 2% or a bit higher when I interviewed him July 17.
But it’s not all peaches and cream. Recent housing data have been more discouraging, with new and existing home sales falling in recent months.
And there are those clouds, chief among them trade policy.
Tariff threats and counter-threats among the US, Canada, China, the European Union, Japan and Mexico have been flying so fast it’s hard to keep up. The surprise announcement as this was written of a US-EU agreement to work toward zero tariff and non-tariff barriers offered hope, but we don’t know the final outcome of these and other trade negotiations. For now trade tensions remain a substantial worry for the Fed.
The generally upbeat beige book reflected the spectre of trade war: “Manufacturers in all Districts expressed concern about tariffs and in many Districts reported higher prices and supply disruptions that they attributed to the new trade policies.”
Powell also registered the FOMC’s trade fear as he testified before Congress on successive days. While telling legislators he preferred to “stay in his lane” and avoid trade policy, and while allowing for a possible positive outcome if President Trump’s trade offensive results in lower tariffs for all, Powell ended up amplifying his concerns.
“Countries that have remained open to trade …have grown faster,” while “countries that have gone in a protectionist direction have done worse,” he said.
Sustained higher tariffs on U.S. soybeans and other agricultural commodities “certainly would be very tough on rural communities, and I think we’d feel it on a national level too,” Powell added.
Emphasizing the need for firms to have “stability” and certainty,” Powell said the Fed has been getting more and more reports that capital investment spending plans have been put “on ice” pending the outcome of trade talks.
The same message came from Harker and Waller, the latter telling me, “We’re getting a lot of comments from contacts … about businesses postponing investment decisions”
“So there seems to be a lot of hesitation now on fixed investment,” he continued. “You may see this show up in the third quarter or fourth quarter. So if that were the case it’s obviously going to be a drag…”
If imports fall as much as exports, there could conceivably be little reduction in net exports (leaving aside dollar exchange rate effects). However, if uncertainty keeps making business more cautious about hiring and investment, it could also make Fed officials more cautious about raising rates. You can be sure some will make that argument anyway.
Powell’s comments on monetary policy may already reflect some of that caution.
“With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that — for now — the best way forward is to keep gradually raising the federal funds rate,” Powell said, repeating he and his fellow policymakers wish to raise rates neither “too slowly” nor “too rapidly.”
That “for now” qualifier got a lot of attention, perhaps more than intended. To me, it reflected not only policymakers’ trade fears but also their uncertainty about how far the actual funds rate is from the putative “neutral” rate. In other words, just how “accommodative” will policy be after another rate hike or two.
Waller’s interpretation was that “for now” signifies “we’re getting to a situation where we might have to do things differently.” Indeed, he said, “it could get to the point where we might have to think about lowering rates….(W)hen you get to neutral you’re in a situation where your next move could be back down, not up…”
The shape of the yield curve will surely impinge on FOMC discussions as well. Since the FOMC’s last rate hike, the spread between the 10-year and two-year Treasury note yields has narrowed to about 25 basis points. Another rate hike could bring an inverted yield curve — long a harbinger of recession.
Until recently, many, including Powell, have downplayed the curve’s flattening and prospects for an inversion, attributing the failure of long-term interest rates to rise commensurately with short-term rates primarily to low term premiums, which they in turn blamed on past quantitative easing.
But increasingly other officials have disputed that argument and advised against assuming that an inverted yield curve will not lead to recession this time.
“If we can avoid it we should avoid it,” Harker told me.
Powell seemed to take a step back from the rationalizations for the worrisome shape of the yield curve in Congressional testimony.
After saying “what really matters” is what signal long rates are sending about the neutral rate, he commented, “if you raise short-term rates higher than long-term rates, then maybe your policy is tighter than you think, or it’s tightening.”
“So I think the shape of the curve is something we’ve talked about quite a lot,” Powell went on. “Different people think about it different ways. Some think about it more than others. I think about it as really the question of what’s that message from the longer run neutral rate.”
One suspects all the talk about this time being different may give way to greater caution the closer the Fed gets to inverting the yield curve.
A final consensus on how many more rate hikes are needed seems unlikely to be reached at this meeting, but it could be the first step in that direction.
As if the FOMC didn’t have enough to worry about with his trade policies, President Trump has also given the Committee something else to think about.
With characteristic insouciance, Trump declared soon after Powell’s monetary policy testimony he was “not happy” and “not thrilled” with the Fed raising rates.
“I don’t like all of this work that we’re putting into the economy and then I see rates going up,” he said. Trump coupled his complaints about Fed rate hikes with suggestions they were undermining efforts to shrink the trade deficit by driving up the dollar.
Trump softened his criticism a bit by calling Powell “a good man” and saying he is “letting them do what they feel is best.” But the damage was done. Financial markets took umbrage.
By the way, it’s not true there’s been a “tradition” of presidents refraining from criticizing the Fed, as some assert.
During the first Bush administration, Treasury Secretary Nicholas Brady and others regularly inveighed against Fed rate hikes. It got to the point where Brady and then-Fed Chairman Alan Greenspan suspended their weekly meetings.
The political pressure did not stop when Bill Clinton became president, as some would have you believe.
Throughout 1993, as it became increasingly obvious the Fed could not keep the funds rate at a then very low 3%, Clinton administration officials repeatedly jawboned the Greenspan Fed to keep rates low.
On Dec. 14, 1993, I found myself across the table from Clinton himself as part of a group of reporters called to the White House for a round of briefings a week before a crucial FOMC meeting. When I asked him how he felt about indications the Fed was about to raise rates to preempt inflation, Clinton responded, “It would be a mistake because there is no inflation threat in this economy. Core inflation is down at quite a low level. Energy prices have fallen so much that overall inflation is quite low; wages are not going up very much, and unemployment is still well over 6%.”
“So there is no indication of a return of inflation, and we need more jobs and higher income,” Clinton continued. “Until a combination of employment, economic activity and rising wages presents some real threat of an inflation rate that is too high, it would be inappropriate for us to choke off a recovery that has already had a false start or two and didn’t move forward in earnest until this past year.”
Clinton told us his deficit reduction plan had laid the foundation for expansion “without inflation.” Besides, “no one can say with a straight face that 6.4% unemployment is a good rate for America.”
Asked whether it would be appropriate for the Fed to act preemptively to tighten credit before inflation actually showed up, Clinton replied, “I just think that right now we don’t need it. I would hate to see us take another step back in the first two quarters of next year. We need sustained, disciplined growth. If we really get to the point where growth gets so robust…there will be ample time to make corrections without having to go to a restrictive policy.”
One of Lloyd Bentsen’s first acts as Clinton’s original Treasury Secretary was to call for “a stronger yen.”
Only later did Bentsen successor Robert Rubin, who had previously pressured the Fed, shift toward a more hands-off policy after realizing pressuring the Fed was driving up bond yields.
More recently, President Obama had no need to bash the Fed.
The Trump administration would do well to realize that little good comes from leaning on the Fed to refrain from raising rates. As a senior Fed official once told me, if anything, he felt more inclined to vote FOR higher rates just to demonstrate the central bank’s independence. Certainly that’s the impression Wall Street gets.
In reality, in recent decades Fed policymakers have nearly always striven to do the right thing for the economy irrespective of political pressure.