Written exclusively for InTouch Capital Markets
27th February 2018
By Steven K. Beckner
Increased optimism about the economic outlook could eventually lead to more aggressive monetary tightening by the Federal Reserve, but that judgment has not come to full fruition. So far the Fed consensus remains centered on caution and gradualism.
While Fed officials have become more upbeat about the economy’s prospects, as reflected in minutes of the Jan. 30-31 Federal Open Market Committee meeting and in more recent communications, few are ready to presume the FOMC needs to significantly steepen the federal funds rate path laid out in December when the Committee made its fifth funds rate hike to 1/14/ to 1 1/2%.
Chairman Jerome Powell’s Tuesday testimony before the House Financial Services Committee was very much in this upbeat, yet tentative vein.
Powell’s testimony shows he and his colleagues are in the process of upwardly adjusting their assessments of the economic outlook, but that does not necessarily mean they are ready to greatly alter their assumptions about “appropriate monetary policy.” Strong growth projections don’t ipso facto lead to faster rate hike projections, particularly when inflation remains below target.
So don’t jump to the conclusion just yet that the FOMC is going to be raising interest rates more aggressively, although that may ultimately transpire.
Powell, presenting the Fed’s semi-annual Monetary Policy Report to Congress for the first time after succeeding Janet Yellen, was unquestionably positive about the economy. “While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds,” he said in prepared testimony.
“In particular, fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory,” he continued. “Despite the recent volatility, financial conditions remain accommodative.”
But Powell was quick to add, “At the same time, inflation remains below our 2% longer-run objective.” So, the FOMC believes “further gradual increases in the federal funds rate will best promote attainment of both of our objectives” — the actual path, as always, “depend(ing) on the economic outlook as informed by incoming data.”
Responding to legislators’ questions, Powell was careful not to “prejudge” the kind of funds rate projections FOMC participants will compile for the March 20-21 meeting and said he has not yet crafted his own, but said recent data suggest a strengthening economy and tightening labor market likely to get a further lift from fiscal policy and from improved global growth.
All this gives him more confidence that inflation is “moving up to target,” said Powell, who said FOMC participants are “going to be taking into account” all these forces in writing down their projections.
As for how tax cuts and increased federal spending will affect the funds rate path, Powell said his “personal outlook for the economy has strengthened since December.”
At another point, he said “it does feel to me the next couple of years look quite strong,” with increased consumer demand, business investment, employment and inflation.
Never once did Powell hint at the need to raise rates more than the three times projected in December, but nor did he shy away from the need to keep steadily removing monetary accommodation, but through rate hikes and balance sheet reduction. The consequences of not doing so would be unacceptable, he suggested.
Things have changed for the Fed, he told the Committee: “It’s important to see that for a long time there was slack in the labor market and that argued for continuing to support lower unemployment, but we’ve reached the point where the risks are really two-sided now, and we need to keep that in mind, because if we do get behind and the economy does overheat, and we don’t see that now, but if does happen, then we will have to raise rates faster, and that raises the chances of recession….”
“That’s why we’re raising rates on a gradual path,” he went on. “We’re trying to balance getting inflation to 2% with the risk of the economy overheating.”
The day before Powell’s testimony, Fed Vice Chairman for Supervision Randall Quarles was almost effusive: “Along many dimensions, it has been quite some time since the economic environment has looked as favorable as it does now… (T)he impetus from fiscal policy has turned distinctly positive with the passage of recent tax and budget legislation.”
Quarles said “it is too early to call a turning point,” but said “it is a possibility that bears consideration.” Among the “encouraging” factors he cited was the leveling off of labor force participation; increased business investment, and faster global growth.
Although weak productivity has held down wage gains, he said “a turnaround could come suddenly.”
Faster growth could require an upgrading of the Fed’s estimate of the natural rate of interest, according to Quarles, who cautioned, “as the natural rate moves up, any given level of the policy rate would be more accommodative, so the policy rate would also have to move up to continue the gradual removal of policy accommodation.”
But faster growth does not necessarily imply an inflationary overheating requiring radical Fed tightening. As Quarles observed, “the degree to which growth spurs inflation is likely to be determined by the underlying factors that are prompting the increase in growth. A demand-led increase can be expected to have a greater positive effect on prices than a step-up in the pace of potential growth.”
“Growth led by an increase in the economy’s productive capacity, either through increased labor force participation or higher productivity growth, is likely to impart less upward pressure on prices.”
And of course, the still restrained pace of wage and price increases gives the FOMC plenty of time to see how much room the economy has to run. Even if inflation overshoots the target for a few months, Powell and company are unlikely to panic, given years of undershooting.
So while we are likely to see upward adjustments in economic and inflation forecasts and some higher funds rate dots in the March Summary of Economic Projections it is doubtful we will see a dramatic shift toward more aggressive tightening.