With the market’s attention increasingly turning to next year, one nagging question seems to linger over the Federal Open Market Committee’s Summary of Economic Projections last week that left a dovish tail to the otherwise hawkish messaging of a fifth rate hike and the affirmation of policy continuity in a gradual pace of rate hikes.
Specifically, the Committee’s median projection for rate hikes in 2018 remained at three, despite the projected surge in real growth to a 2.5% median from 2.1% in September, which Chair Janet Yellen explained was due to most of the FOMC penciling in a tax cut-driven fiscal boost to their 2018 growth projections.
*** Left unstated, however, we understand that the median of the rate hikes stayed at three in large part to ensure the fiscal boost to aggregate demand would be enough to lift inflation and keep the core inflation forecast on track at 1.9% next year. In other words, without the fiscal boost, the core inflation forecast might have fallen short of September’s projection, a downward turn in the forecast the FOMC shunned. In that sense, the expected fiscal stimulus next year is not only welcomed, but needed in order to break the persistence in low inflation and blunt the risk of falling inflation expectations. ***
*** We still think a rate hike at next year’s March FOMC meeting is more likely than not, mostly because we suspect the fiscal stimulus will be even larger than currently projected (SGH 12/13/17, “Capitol Hill: The Scale of Stimulus”) and because financial market excesses may enter into the policy calculation. But low inflation and the Fed’s anxieties over structural changes in inflation dynamics may come to offer enough of a counterweight to make the meeting’s rate decision more open to debate than would seem likely against the backdrop of significantly stronger aggregate demand and rising asset prices. ***
*** And while the fiscal stimulus may resolve the Fed’s narrow near term dilemma over the low inflation question, beyond March the Fed’s policy debate will invariably be shifting to how quickly, if at all, the current effective neutral rate will be rising towards its longer run levels and thus the ultimate terminal point to the current policy normalization strategy. More broadly and further down the road, the scale of the fiscal factor at such a late phase of a long, albeit tepid, expansion may also elevate the risks of a policy error in an excessive tightening, all under a new Chair and an unprecedented turnover on the FOMC. ***
An Echo of March 2016
The tweaks in the projections to the appropriate rate policy path last week were in some ways an echo of the adjustments in the rate path made in March 2016. In December 2015, the FOMC had finally pulled the trigger on a first rate hike, but the accompanying rate dot plot showed a median of four hikes in 2016, with the markets cracking in January and early February.
The Fed forecasters quickly reset the rate dots to a more dovish pace by March, which had the effect of protecting the December growth forecast that was essentially unchanged, and as though nothing had ever happened.
In this case, a similar tweak to the appropriate path of the policy rate would appear to have been necessary to make the higher growth projections, an unemployment rate that would only tighten to 3.9% by year-end from the current 4.1%, and an inflation rate held steady at 1.9%, all hold together.
The problem for the Fed forecasters by the time the December SEP forecasts were being put together was the persistence in the so-called “mystery” of the low inflation and the still unanswered questions over possible structural changes in the inflation dynamics.
The Committee majority’s base case assumption remains for the idiosyncratic and transitory factors holding inflation down this year to start rolling out of the data by next spring. That in turn will allow a still tightening labor market well below its longer run levels to finally exert the long anticipated upward pressures on prices through the year. Indeed, this more fundamental, slack-based inflation dynamic means an outright tightening of monetary policy will be necessary by 2020 with a majority of the Committee marking rates north of the 2.8% estimates for the longer run neutral rate.
But that said, the more immediate concerns of the more dovish FOMC members seems to have spread with some sympathy across the wider Committee, despite the base case outlook. The low inflation this year, for instance, may persist for longer than expected, with unforeseen structural factors continuing to repress the model-based assumptions of higher inflation.
Core inflation, in one scenario, may indeed rise back to its prior levels after this year’s “idiosyncratic” factors roll out of the data through spring next year as expected, but then trend sideways again, rising no higher than perhaps 1.7% or 1.8% despite the tightening labor market and growth well above estimated trend levels.
A further implication was that there remains more slack in the outer edges of the labor market with room for the labor participation rate to still rise at least some despite the longer, stronger demographic trends in the reverse direction — which Chair-designate Powell in fact hinted at in his confirmation hearings last month.
In other words, absent the penciled in fiscal stimulus to aggregate demand of the tax cuts that are literally being voted on today and tonight, there would not have been enough demand to push inflation higher.
That, in turn, would have meant the core inflation projection in December could have come up short of September’s 1.9% projection, a reversal in the inflation trend-line the Committee majority would not want to put into a forecast.
So to ensure the fiscal stimulus has its desired effects on inflation, the appropriate path for the policy rate had to be restrained, for now, holding to the median of three rate hikes in 2018 rather than nudging the pace to four hikes that might have been expected amid such a large scale boost to demand and growth.
Fiscal as Savior
As it is, the fiscal stimulus could not have come at a better time, a savior of sorts in resolving the Fed’s internal debate over inflation dynamics.
At minimum, the prolonged undershoot on the inflation mandate affords the Fed the luxury of a still gradual pace of rate hikes despite the boost to demand and sustained higher than trend growth. It should also neutralize the anxieties over further declines in the measures and surveys of inflation expectations.
The Fed may of course have far more on their hands to deal with, in trading a problem with inflation persistently too low for inflation with a momentum too persistent to blunt without a more forceful policy response. And before that, the FOMC will be tackling the debate over the neutral rate, whether the current effective neutral will indeed be rising, if at all, to its estimated longer run levels.
At the same time, as we noted earlier, we think by the time Congress is done extending the Continuing Resolutions to the FY2018 budget, the fiscal stimulus of the tax cuts will be further boosted by even higher than generally assumed spending that the FOMC will invariably have to incorporate into revised SEP forecasts at the March meeting.
So, on balance, we still think a rate hike in March remains more likely than not. And if for any other reason — assuming the data and forecast underpin it — a rate hike would afford a new Chairman and the FOMC the flexibility of choosing the timing and pace to future rate hikes and would put the market on notice for potentially another three hikes through the year even if the Committee in the end opted for less.