Fed: Backloaded

Published on March 12, 2018

With a solid and reassuring Non-Farms Payroll report safely in the rearview mirror, attention will now be turning to the March 20-21 Federal Open Market Committee meeting next week. In particular, there is likely to be a particular interest in how the FOMC incorporates the two-year budget deal, which came together after the January FOMC meeting‎, into the rate trajectory over the three-year forecasting horizon.

*** An all but certain rate hike at the March meeting will be framed with a more clearly hawkish tilt in the statement, with the “roughly” finally deleted from the near risk assessment and upgrades to the descriptive first paragraph on the economic outlook. A highly stimulative fiscal policy may also draw a mention. In the wake of the employment report on Friday, we are even more confident the March rate dot plot will reflect a solidifying Committee consensus around a median three rate hikes for 2018 in the Summary of Economic Projections. ***

*** In his first post-meeting press conference, Federal Reserve Chairman Jerome Powell is likely to stress a “three-plus” base case of three rate hikes this year, taking care to note the option for a fourth “if needed,” depending on how inflation plays out through the year. He may also echo Vice Chair Randal Quarles in noting a possible, eventual higher trend growth. The Chairman is also likely to assert that if that fourth rate comes later this year, it would still be “gradualist” rather than signaling a quickened tempo in the pace of rates normalization. ***

*** That gradualist message, however, will be under considerable strain when the scale of the fiscal stimulus is more clearly evident in the March revised SEP growth forecasts. The additional fiscal stimulus of the two-year budget deal on top of the December tax cut seems likely to boost 2018 median growth to as high as 2.8%, or at least a full point over potential growth. And crucially, instead of December’s projected fade in the tax cut-driven growth next year, real growth in 2019, and 2020, is also likely to be marked substantially higher as well. ***

*** Even if trend growth is marked up to reflect an optimistic interpretation of the supply-side effects of tax cuts, or the median Nairu estimates are nudged higher, our sense is that significantly steeper rate hikes will be backloaded into the 2019 and 2020 rate projections. By 2020, all 15 of the rate dots could be marked above longer run neutral into an outright rate tightening to quell inflationary pressures. An overshoot of the 2% inflation target may also be formally acknowledged in the projections and by Chairman Powell in his press remarks. ***

The NFP and a Three Hike Consensus for 2018

It is rare that a single data point should signal an outlook that is about as good as it can get, but Friday’s Nonfarm Payrolls print did just that. In particular, the takeaway most prized by Fed officials in the employment report was the pleasantly surprising pick up in the labor participation rate. It suggests there is indeed more slack on the outer edges of a tightening labor market than previously assumed.

Such a big jump by three tenths to 63%, in defiance of the secular downward demographic trend and which kept the unemployment rate steady at 4.1%, signals a high-pressure economy that can absorb 313,000 net new jobs in a single month without threatening inflationary pressures any time soon. The fallback in the hourly earnings was somewhat disappointing but it was expected to some extent, with a very gradual but steady upward wage growth rising above 3% only in the second half of the year.

More importantly, taken together, Friday neatly reinforced the case for a continued, cautious pace of rates normalization in gradually removing monetary accommodation. The upcoming key data points like the CPI and retail sales are not expected to spring surprises that would jar the forecasts being compiled this week for the March meeting.

The recent run of the data also neatly fit with what we believe is a solidifying consensus of Committee members marking three rate hikes in their rate dot projections for the March meeting. Governor Lael Brainard’s well-crafted speech — we especially liked her “mirror” metaphor — before the New York Money Marketeers last week reflected a likely movement of several more dovish-leaning Committee members to the centrist three rate projection.

And we likewise expect the “Core Four” of centrists — Chairman Powell, Vice Chairman Quarles, New York’s Bill Dudley, and San Francisco’s voting John Williams — will hold the line at three rate hikes this year as well (see SGH 2/20/18, “Fed: The Powell Messaging” and SGH 2/28/18, “Fed: Opening Four”).

The reasons for signaling a modestly more cautious gradualist path in 2018 at the March meeting has mostly to do with the timing of the March meeting rather than indicating actual probabilities of whether that fourth hike is indeed more likely than not.

While the FOMC majority is very clearly far more confident in the economic outlook, the scars of undershooting the inflation target for so long — literally every year since the 2% target was formally adopted in 2012 — is likely to leave its mark in the slightest of hesitation among many if not most Committee members needing to see clearer evidence the expected underlying inflation is indeed rising. And that may point to the June meeting rather than March before there is enough data to see what lies in terms of the underlying inflation underneath the idiosyncratic” downward pressures of last spring dropping out of the year-on-year data.

And as San Francisco’s Williams noted in recent remarks to the press, it may be still just a tad early to model the full effects of the tax cuts on the economy, certainly on the supply side, and equally on its possible effects on whether the short run R* is perhaps rising towards its longer run levels a bit more quickly than previously assumed.

Our sense is that the FOMC is more or less evenly split on the level of the short run neutral, with perhaps a slight majority remaining quite skeptical it is rising more quickly this year. So again, it would be nice to have through at least the early summer and going into the June and July meetings before making that judgment call.

Game Changing Fiscal Stimulus in 2019 and 2020 

But the fiscal stimulus effects of the tax cuts — and especially the two-year budget deal reached in early February and after the FOMC January meeting — is likely to show up in the March projections, and could potentially prove to be a policy game changer. The market should see the first signs of its impact on the Fed’s assumed appropriate policy path in the March SEPs and rate dot plots.

The Bipartisan Budget Act, passed in early February with a 71-28 Senate vote and a 240-186 House vote, removes the prior sequester caps on spending and allows for a boost to defense and non-defense discretionary spending by just under $300 billion over two years. Around half that is being packed into the spending bills being drafted for an Omnibus for the current fiscal year ending September 30 that the GOP leadership hopes to pass before the current Continuing Resolution expires March 23.

For defense spending, there will be another $80 billion in the current fiscal year ending October 1, and another $85 billion in FY2019, while the limit on non-defense spending would increase by $63 billion this year and $68 billion next year.

In addition, there is another $260 billion coming in off-budget spending for the war-related Overseas Contingency Operations, and emergency disaster aid. Federal borrowing is projected to rise by 84% to nearly $1 trillion this year this year alone.

There is around $100 billion in offsets — among them another raid on the Federal Reserve surplus funds — but that is an awful lot of new stimulus of federal spending about to be thrust into an economy (see SGH 12/13/17, “Capitol Hill: The Scale of Stimulus”).

Governor Brainard put the additional fiscal boost to growth this year and next at around four tenths in each year, which is on top of the four tenths the FOMC had added to the median in the December forecasts, based on the preliminary estimates of the tax cut effects. If the stimulus to growth this year is anything near Brainard’s estimate, the median growth projection for 2018 in March could easily be marked up to 2.8%, or a full 1% above the estimated trend growth.

But more importantly, the budget deal is even more of a 2019 story — and for 2020 and beyond for that matter, since the new budget baseline will be running that much higher starting in FY 2021 — because the Fed has previously penciled in a relatively short “sugar high” from the tax cuts, with its impact on growth and demand already fading in 2019 to a real growth estimated at only 2.1%. That, with the effects of interest rates that by 2019 will have reached and be slowly rising with a rising short-run neutral level, would be enough to have pushed inflation back to settling in around its 2% mandate-consistent levels.

But the higher burst of federal spending in the second year of the budget deal seems likely to change that equation: instead of a fading fiscal stimulus to take some of the pressure off rising price pressures, almost the reverse will be true with another dollop of spending further pushing up demand and with it, further downward pressure on the unemployment rate that is already well under just about anyone’s estimate of its longer run levels.

The FOMC’s patience with several more years of undershooting its unemployment mandate will run for only so long. That is why we suspect the changes in the Fed’s base case rate outlook will be more clearly seen and felt, not in 2018, but in the rate dot plots for 2019 and 2020 with significantly higher rates being plotted in later years of the forecasting horizon (and in September, we will see the 2021 rate dots, which will be interesting).

At least one more rate hike in the 2019 rate dot plot over the December’s two hike median is likely to make its way into the March median, and certainly two more if three hikes proves to be the case this year. For the 2020 rate dot plot, we suspect all 19 of the rate projections will be above the member’s forecasts for the nominal longer run neutral level, meaning the Powell-led FOMC will be already expecting an outright rate tightening in order to quell the inflationary pressures of by then clearly overheating economy.

Overshooting the Inflation Target

There can be, of course, a mix of tweaks to the projections to make the math of the SEPs work more coherently into a gradualist rate narrative. But our sense is for several years of undershooting the employment mandate also translating into an overshoot of the 2% inflation target to absorb some of the risk for even higher rates in 2020.

A formal overshoot may show up in the actual March median projection for core PCE, but even if not, it will almost certainly show up in the full range of the projections with more forecasts being marked above 2% before they are topped and tailed for the central tendency forecast, which will again show at least a 2.1% on the high end of its narrowed range.

Almost every FOMC member has paid lip service to the symmetry of the inflation target, and the more dovish members succeeded last year in getting the point hardened up in the annual Statement on Longer-Run Goals and Monetary Strategy. Indeed, we think Chairman Powell, if asked, will confirm a Fed willingness to tolerate an overshoot of the 2% inflation target, albeit one that is modest, temporary, and essentially accidental rather than engineered.

But it is one thing to rhetorically acknowledge the willingness to tolerate a (temporary) overshoot of the target, it is still another to pencil it into a forecast. The effects on anchored inflation expectations is still uncertain, and it would a big prize to lose if those expectations become unanchored.

Any movement towards an acceptance of a possible inflation overshoot making its way into the forecasts, then, could perhaps be the single most important takeaway in March.

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