The unexpected persistence of low inflation has been driving much of the internal policy debate across the Federal Reserve system for some time now, squarely placing the issue at the heart of the Fed’s coming review of its policy framework. But the prospect of a further weakening in inflation, despite an expected second quarter rebound in economic activity, appears to be radically reshaping the Federal Open Market Committee’s nearer term rate policy options.
*** While there is little chance the FOMC will be weighing a rate move at its meeting next week, with rates remaining on hold, a scenario for a near term rate cut, as a “recalibration” to the Fed’s current policy stance, is likely to be laid out by several members at next week’s meeting: the recent softness in inflation is pointing to a NAIRU estimate even lower than the current 3.8% unemployment rate and a short run r* below the current 2.4% policy rate; crucially, the rate cut would a pre-emptive “insurance” against the economy ever slowing, much less slipping towards recession, and could come despite stronger growth in the first half of this year if inflation weakens or looks to be trending below its 2% target. ***
*** This aggressively dovish case is for now a distinctly minority view and would need to come to terms with unavoidably awkward political optics. But all else being equal, a downshift in the policy stance to a lower equilibrium level could gain broader support within the FOMC as soon as the June FOMC meeting and remain on the table through probably at least September. Growth that fails to rebound or core inflation that continues to weaken would bolster the case for a rate cut, but we think the key to any new consensus on the rate stance would be an agreed shift in the reaction function towards a more pre-emptive rather than reactive, more conventional tact in first waiting for faltering growth or weakening inflation to appear in the data. ***
*** Signs the more aggressive policy posture is gaining support within the Committee to put a rate recalibration in play, we think, would first become evident in a Fed policy messaging in the coming weeks that accents more broadly among its members a lower than assumed neutral and a more frequent and elevated emphasis on the social and economic pay-offs in an extended “high pressure” economy. We suspect the debate on the implications of persistently low inflation at the Fed’s review of its policy framework in early June will also lend weight to any newly emerging consensus on the policy path going forward. ***
A Newly Emerging Intellectual Center to the FOMC
With the FOMC going into its pre April 30-May 1 meeting blackout this week, a few points are in order as the Fed enters into the second, perhaps defining, year of Chairman Jerome Powell’s leadership.
The first is that while it seems a newly emerging intellectual center of the FOMC is building towards a dovish near term rate cut, the FOMC majority is for now still holding to the base case for an extended rates pause, and waiting for less noisy data through summer before weighing a policy reset. The healthier looking first quarter data are also bolstering the caution to stay the course on the pause.
But our sense is this majority view is not as solid as the recent consistency in the Fed’s policy messaging would suggest. Pivotal to any shifts in the Committee rates consensus will be the evolving views across the Fed on the nature of the inflation process, be it the eventual effects of the core Phillips Curve assumptions at the heart of the Fed’s slack-based inflation forecasting or by how much and for how long to factor in “transitory” influences like global price trends or the dominance of firmly anchored inflation expectations that could be modestly slipping lower.
A key turning point in the Fed assessment of inflation and its risk management calculations in fact had already come in the run up to the December meeting.
Inflation was then forecast to remain nearly as inertial and slow moving as it had been the previous few years, but to at least be rising ever so slightly back to around its 2% target going into the turn of the year. Meanwhile, the lagged effects of the accumulative rate hikes would slow economic activity enough to provide for a soft landing in 2019.
But instead, core inflation softened further. And to have barely reached its 2% target after what had been a massive twin fiscal stimulus in the late 2017 “Tax Cuts and Jobs Act” and in the early 2018 “Bipartisan Budget Act” was troubling enough; we understand that many Fed staff forecasts are currently penciling in further slippage in core inflation to 1.8% or lower — and that is still assuming a decent rebound in growth after the first quarter slowdown.
That downward drift in the various measures of core price pressures rather than any slower growth or recession risk is the key to the new dovish arguments we sense being put forward inside the Committee.
A quick, sharp downshift in rates, by perhaps as much as 50 basis points, to a new lower equilibrium level, it is being argued, would help to push inflation expectations higher and could even nudge inflation into an eventual overshoot of the 2% target, neither of which would be unwelcomed developments.
At its heart is a new assessment of the risk management calculation: a limited upside cost in correcting the “recalibration” to a lower policy rate reset if it should prove to be a premature easing, versus a widely shared concern across the FOMC in how daunting a task it could prove to be to reverse a southern turn in growth towards recession, especially when a rapid return to the Zero Lower Bound looms, or a deepening, Japan-looking decline in inflation expectations.
What’s more, the flip side of upside benefits to a recalibration of rates, even if juicing the economy with a bit more accommodation for longer — would be considerable: an extended high pressure economic growth would continue to mop up every last corner of labor market slack, drive up or at least stabilize the participation rate, nudge wages higher, and even work towards a rebalancing between labor and capital in the process.
Perhaps most of all, the lower policy rate just might push an excessively cautious and gun-shy corporate sector into productivity-enhancing investments that lift the economy’s trend potential. In that sense, resetting the policy rate lower by perhaps 50 basis points would be a logical next phase to the policy pivot taken over the turn of the year.
A Prized Analogy to 1995, But Horrendous Political Optics
On that score, there is an interesting analogy being made to 1995 when Fed policy under former Chairman Alan Greenspan went from a 25 basis point hike in the fed funds rate to 6% in February — culminating a rapid 300 basis points in tightening from the prior February — to a rate cut in July, followed by another rate cut in September to dial fed funds back to 5.5%.
In that case, a Fed policy tightening cycle that was so quickly reversed into a 50 basis point easing came to be lauded as a crucial mid-course correction that ensured a fabled “soft landing” of the economy without a recession.
That, in turn, cleared the path to an extended recovery and a prized “high-pressure” economy of low unemployment, rising wages, and a budget surplus by the end of the decade, after Greenspan so famously had his hunch about rising productivity that neutralized an anticipated surge in inflation.
But against the backdrop of President Trump’s relentless criticisms and the controversies over the qualifications of the two current nominees floated to the Fed’s Board of Governors, a far less appealing scenario is also being commonly drawn, to the early 1970s when former Fed Chairman Arthur Burns infamously ceded to then President Richard Nixon’s pressure to juice the economy with an accommodative policy going into the 1972 elections. The scarring fires of the Great Inflation soon followed.
Fed officials across the Committee appear to be extremely uncomfortable with the optics of any near term rate move that could lend to the appearance of being politically dictated rather than internally driven on its merits alone. That imperative to protect the Fed’s credibility could push any rate cut consensus back to September or later, if at all.