The Federal Open Market Committee’s year-end meeting next week is one of those where all the market focus will not be on the policy actions announced on Wednesday, but almost exclusively on what will be signaled about the Fed’s rate path going forward, and especially the probabilities for a March meeting rate hike.
Three takeaways on next week:
*** The statement will be quite upbeat on the economic outlook, and may acknowledge the potential fiscal policy boost to growth next year. The inflation language is likely to remain unchanged, as is the affirmation that policy remains accommodative and that conditions are still likely to warrant gradual rate increases. While some Committee members may pencil in some fiscal stimulus into their rate dot projections, on balance, we expect the median to remain at three hikes in 2018. The certain hike in fed funds to 1.25%-1.5% will bring the Fed to perhaps only one or at most two hikes away from the presumed current neutral rate just this side of 2%. ***
*** Most of the signaling for next year’s policy path will come in Chair Janet Yellen’s final post-meeting press conference. We think she will avoid any overtly dovish messaging, and while we expect her to again acknowledge the Committee concern she shares over uncertain inflation dynamics, she will reaffirm the Fed’s expectations for higher inflation through next year. Her tone may in fact seem relatively hawkish if she cautions, as we expect she might, on the Fed’s watchful eye on financial market excesses next year or in laying out scenarios for the Fed’s possible reaction function to a major tax and fiscal boost to demand. ***
*** Indeed, we suspect the FOMC will want a hawkish tilt coming out of next Wednesday in the expectation the legislation likely to be passed this month will be tipping the base case at the March meeting to another rate hike. Incoming Chairman Jerome Powell could quickly be facing a “defining” moment early in his term. He will need to craft a Committee consensus amid political pressures to slow-go further rate increases and a likely cross current of fiscally-driven higher demand, surging market valuations, and a below 4% unemployment rate, but with a still serious risk of embedding lower inflation expectations if the expected higher inflation is a no-show in the data. ***
Too Early for SEP Fiscal Effects
To no small degree, this Friday’s Non-Farm Payroll may set the mood for the two days of FOMC policy deliberations next Tuesday and Wednesday. Barring a shock drop in job creation to below, say, 100,000, any job print north of 150,000 will be judged a clear indication of a still tightening labor market.
And depending on the movement in the labor participation rate, the headline unemployment number could dip to 4% from the expected unchanged 4.1%, which is already well under anybody’s estimate of NAIRU. And there could be a surprise in the Average Hourly Earnings that would provide a fillip of confidence in the Fed’s slack-based models that point to eventual, rising price pressures.
In other words, the bias in how the NFP will be assessed and fed into the forecasting models for the meeting is to the upside which, in turn, should help underpin the arguments of the hawk and centrist Committee majority for not only a rate hike but for a hawkish tilt to the policy messaging into the new year.
But despite market chatter of a significantly higher 2018 rate dot plot due to the presumed fiscal boost to growth, the FOMC will not in fact have any hard numbers from Capitol Hill on the size and scale of tax cuts or the spending increases that could be confidently factored into the new SEPs for the December meeting.
The Summary of Economic Projections and the rate dot projections are literally being finished this week and will be submitted this coming Friday, or well before there will be any final tax cut bill or Continuing Resolution heading to President’s desk for signing into law. So like the NFP, the overhang of a looming fiscal boost will serve more as a mood setter than a big booster shot to the forecasts and rate trajectory.
Against that backdrop, we think the median real growth forecast is likely to be marked up for next year to at least 2.2% if not higher, depending on how many members do begin penciling in some fiscal boost to demand. But the longer run growth estimate will remain at 1.8%, underscoring the need for continued rate hikes beyond 2%; few, if any of the FOMC are assuming any boost to productivity just yet.
Those assumptions for a fiscal boost to demand in an economy already at maximum employment and above trend growth may be one reason that, for all the anxieties stressed in recent weeks and months over the persistence in low inflation and the risks in sustained declines in inflation expectations, we don’t expect the September 1.9% core inflation forecast for 2018 to be tweaked down.
We would be impressed if more FOMC members penciled in higher than 2% inflation in the outer years of the forecast, enough of them to lift to the central tendency narrowed range above 2%. But for now, that still seems to be a mark of policy failure, so most staff shy away from an engineered overshoot and hold the inflation forecast to a 2% inflation target. Instead the tendency is to mark up the pace of rate hikes to dampen the presumed price pressures after several years of below NAIRU employment to make the numbers work for a 2% inflation.
The headline unemployment rate is likely to show further labor market tightening, probably being dropped down to a median of 4.0% if not 3.9%, with a more noticeable drop in the ranges to perhaps 3.7%-4.3%. The longer run unemployment estimate may also be nudged down, to 4.5%, but which still translates into several years of below NAIRU labor market tightening. That should presumably be soaking up the last of the slack around the labor market edges in the participation rate uncertainties mentioned by Chairman-designate Powell in his testimony last week.
That said, a handful of Committee members, as they did last December after Donald Trump’s election, are still likely to pencil in at least some fiscal stimulus into their forecasts and thus the underlying appropriate policy rate they map out in the rate dot plots. So we expect only a few rate dots to be marked higher in December, but more are likely to stay the same and a few could even dip due to concerns over uncertain inflation dynamics.
On balance, our expectation would be for the median to stay at three rate hikes, but for the dot matrix to perhaps look more dispersed and elongated. We won’t bother to comment on the rate dots in 2019 and 2020 until at least March, as they will probably mean even less than ever, and there is still to be so much Board turnover next year.
And indeed, it will be the March meeting, not December, that the fiscal effects will truly make their way into the Fed forecasts and likely reaction function, as well as perhaps, even some resolution of the inflation “mystery.”
A “Defining” March Meeting
The March meeting is, frankly, too far away, for Fed officials to be thinking about it other than in the most general terms. Our sense is for a default policy stance in March of higher than even probabilities for a rate hike, but there are multiple uncertainties between any December meeting signaling and the actual decision at the meeting.
The least of which is obviously the size and scale of the net stimulus to demand and investments that will come from the bill to cut taxes with such a large built-in deficit and the added discretionary spending that will go into the final votes to pass the FY2018 Continuing Resolution. Any numbers are uncertain at best, but something in the ballpark of an extra $100 billion to $120 billion or more may be in the works.
For an economy that is already running at above trend growth and a labor market tightening up considerably in running now well NAIRU for some time, that is a lot of net new stimulus to tack on without the Fed assuming the emergence at long last of that rising inflation through next year.
And the concerns over inflation expectations aside, the bet among a majority of the FOMC is for the Phillips Curve effects to indeed kick in sooner or later, and in this case, the fiscal boost may be a welcomed relief to the anxieties of the mystery of what happened to the pent-up wage deflation and underlying labor market pressures on prices.
The catch is, however, that the inflation data is unlikely to show much movement by the February figures, which will be the latest going into the projections for the March meeting. Nor will there be much impact on real growth just yet, other than, invariably, another shot of adrenalin in forward pricing equity markets. So it may prove to be a meeting that will turn on the forecast rather than with the benefit of the so far elusive clear evidence of rising inflation.
Indeed, something of a nightmare scenario for a new Chair and an FOMC with several new members will be upward spiking markets and upwardly revised growth forecasts but a no-show of inflation.
Powell is understood to be modestly more sensitive to financial market excesses and the risk of a sharp reversal than, say, the departing Yellen, and he would not want to send any sort of dovish signals to a grasping for return market by not hiking. On the other hand, it would be a courageous Fed Chairman to say he was hiking solely because market valuations look excessive.
So there may be no one more than the incoming Chairman wishing for a bit of clarity on fiscal effects and for even just a sliver of evidence for inflation to indeed be rising in goods and services and not just in financial asset prices.