Fed: A Premium on Policy Flexibility

Published on November 16, 2018

In case it wasn’t clear to anyone that Federal Reserve Chairman Jerome Powell thinks the US economy is in a “good place” right now, he repeated what “good shape” the economy was in about a bazillion times during his roadshow in Dallas and Houston earlier this week. It reminds us of the exclamation point he put into his remarks on “strong economic conditions” in Sintra last summer, which had to be a first in the history of Fed chairmen.

But beyond the target “audience of one” that his upbeat assessment is no doubt directed, three points stand out to us in terms of the Fed policy path going forward:

*** Despite the market taking some recent remarks by some Fed officials to be dovish signaling, there remains in fact an unusually solid Committee near-term consensus to keep on track with a gradual pace of rate hikes. For different reasons and with varying degrees of confidence, the Committee’s mainstream hawks have been joined by newly hawkish Phillips Curve doves, and most recently by Board supply side optimists, all of whom are looking in the same northern direction on rates. Under current projections, that translates into the mid-December rate hike and a likely hike in March or May next year. ***

*** Once at or very near a neutral policy stance, however, without clear evidence the underlying inflation is moving higher or faster than projected, we suspect that currently hawkish lean to the Committee consensus will begin to fray. That would in effect open the door to a “pause” — its meaning admittedly a bit more vague with every meeting now “live” — but more importantly, it will mark when the Fed’s reaction function is truly on a data-driven, meeting to meeting approach, with a premium on a policy flexibility to nimbly slow, maintain, or quicken what is still likely to be an upward rate trajectory. ***

*** In other words, we would interpret the thrust of recent policy messaging not to be dovish or hawkish on the rate outlook next year, but a positioning for a more nimble reaction function, driven by two uncertainties: the divergence in the outlook, whether the fiscal stimulus will fade, if the trade wars will slow growth or stoke inflation, and whether inflation will remain inertial despite the near high pressure growth; internally, the doubtful reliability of the Fed’s traditional navigational guides — the “celestial stars” as Powell put it — likewise adds to the Fed’s sense of caution and need for policy flexibility. *** 

The Impact of Slowing Growth

While several Fed officials have acknowledged slowing global growth and the likelihood of headwinds looming on the policy horizon next year, it is the near term forecast for still robust US growth that is keeping the Fed on track for the December hike, and more likely than not, at least one more hike in the spring next year.

It was only two months ago that the 2018 real growth projection in September was sharply raised by three tenths to a median 3.1%, with the 2.9-3.2% range of the submissions skewed towards the high side before they were topped and tailed for the narrower central tendency. That compares to the median estimate for trend growth of only 1.8%.

More to the point in the current near base case rate path is how and why the Fed forecasts real growth to scale back considerably next year to a median of 2.5%, and dropping all the way back to 2% by the end of 2019. 

Two things stand out in how the Fed is framing the current market nervousness over the impact on rates in slowing growth: first, most of the headwinds now being cited such as slower global growth or — critically — a fading fiscal stimulus, are already factored into the forecast; secondly, a barely budging core PCE at only 2.1 % across the forecasting horizon is built around the higher rate trajectory of the Fed’s rate dot plots compared to the current market expectations, presumably all the way north to 3.4% by year-end 2020.

There is, in other words, a calculation in the balance of risks that inflationary pressures could still be rising even if growth decelerates next year due to the headwinds now being acknowledged. In the meantime, the policy path is firmly aimed at the necessary rate increases to get a little deeper into the range of Fed forecasts for where a truly neutral policy lies.

So unless the Fed just in the last week or so is suddenly factoring in a much sooner than expected turn to the south for the economy — and there is no evidence the FOMC is shifting its views that would come anywhere near to validating market anxieties over faltering stock prices or the recession chatter of an over-reaching Fed policy error — there is nothing in the thrust of the recent Fed remarks that is the stuff of a near term dovish policy signal.

Instead, the gradual pace of rate increases firmly remains the base case for almost the entire Committee that is unusually solid in its near hawkish policy stance.

The Near-term Rate Consensus

To our ears, the traditional hawk-dove split has given way to an alignment of three overlapping views within the Committee with two of their dovish colleagues somewhat isolated. Mainstream Committee hawks remain as firmly convinced of an “acceleration” inflation risk as ever while previously dovish Phillips Curve faithful are scaling their risks assessments to the upside with slack-scarce labor market eventually, surely, leading to higher inflation; and more recently, these two groups have been joined by a chorus from the Board leadership voicing an optimism that productivity-enhancing investments just may be finally picking up on a scale that raises the economy’s potential growth.

The views of the latter obviously influential group, more than faintly reflecting the Trump Administration’s dearest ambitions for the tax cuts, are not widely shared across the FOMC or the staff, if at all, with the median of trend growth estimates standing firm at 1.8%. The most recent data showing a falling off in the pace of corporate investment spending likewise doesn’t portend well for their argument.

But more to the point on the rate trajectory is that a rising trend growth, if it comes about, doesn’t necessarily mean a dovish ending to the rate tightening; rather, it only means the Fed will still need to raise rates, albeit for a different reason. In an echo of Governor Lael Brainard’s earlier arguments about a rising short run r* exceeding its longer run estimate, the supply side optimists are arguing a higher trend growth for the economy will need rising rates just to stay at a neutral policy stance.

The takeaway, in other words, is that short of a true downside shock, across the current consensus of the Committee, it is only the pace of the Fed’s upward rate trajectory that could be in play, not its direction.

A Nimbler Reaction Function

Where we would take the seeming dovish public remarks by more than a handful of FOMC members is in positioning the Fed in working towards that, once to neutral, they believe policy will need to be very flexible, with rate decisions nimbly taken at any of the eight meetings year. Rate decisions will be taken on a meeting to meeting basis — perhaps the truest definition of “normalized” policy — and which could entail a slowing or quickening to the base case for continued gradual increases mapped out in the rate dot plot in the most recent September Summary of Economic Projections.

The reason is the wide variance of uncertain drivers to the base case median economic forecast, which we have highlighted in earlier reports (see, for instance, SGH 8/20/18, “Fed: Jackson Hole, For Now”). Chairman Powell, for instance, cited potential headwinds to the downside earlier this week, including slowing global growth, the expected fade in the fiscal stimulus, and the lagged effects of the cumulative rate hikes since late 2015.

Among them, that the Democratic-driven House may drive yet another mostly debt-financed fiscal stimulus (see SGH 9/10/18, “US: Midterms, Trade, and a “Fiscal Accelerator”) is a political development that stands above the other headwinds and tailwinds being very closely watched by Fed officials as a potential game changer for rates policy.

Our sense is that the Committee’s eventual consensus on how long and to what extent fiscal policy will stretch the economy’s labor and productive capacity is a primary reason for the almost binary upper and lower range of rate projections for 2020 in which there were only two Committee members with rate dot projections at the actual median.

With such a wide variance of possible economic outcomes next year, and with the economy more or less at full employment and at mandate-consistent inflation levels, monetary policy once to neutral may need to move quickly to the signals gleaned from the noise of the data.

If growth next year does indeed slow more quickly and deeper than forecast, the Fed will be positioned to slow its pace of rate increases, or if there is indeed another major fiscal boost to aggregate demand, it may potentially need to quicken the pace of rate increase to counter the elevated risk of excesses, in either financial asset prices or inflation, or both.

The lack of noteworthy upward inflation momentum will be critical. It is for now being taken as an affirmation the pre-emptive “sooner and slower” rates normalization under former Chair Janet Yellen succeeded in dampening an accelerating inflation or an unanchoring of tempered inflation expectations.

It also means Chairman Powell can keep to the gradual ascent to neutral that dries up the last of any remaining labor market slack to drive up real wages and, hopefully, press firms to invest and in time, drive up productivity and the economy’s trend potential.

But nowhere is there, for now, an internal movement towards a hard stance to signal a terminal point to the rate increases anywhere on the near horizon. The Committee’s two lonely doves are sticking to their guns in arguing that policy is already at neutral and at risk of a policy error if the upward rate trajectory continues. But the inflection point for that decision, for now, is unlikely much before next spring.

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