Against the backdrop of the somewhat hawkish undertones to Federal Reserve Chair Janet Yellen’s remarks at the Commonwealth Club in San Francisco yesterday, Yellen will give what is likely to be a major policy speech detailing a bit more on how she is framing Fed policy going forward.
As a warm up to the speech, some points to note:
*** There is a solid Federal Open Market Committee consensus on the likely need to quicken the pace of rate hikes this year relative to the single hike in each of the last two years. But the actual path of rate hikes, certainly in the first half of this year, will be driven by inflation concerns rather than the anticipated effects of fiscal policy. We still think the base case is two rate hikes this year, with a third possible if not probable, while four hikes are as unlikely as just one. ***
*** We strongly doubt the FOMC will hike rates again before the June meeting. To seriously put a hike on the table at the mid- March meeting, inflation would have to display an unlikely consistency in edging north of expectations in the next two months. And even then, an accelerating inflation would tend to cement the June move and elevate the probabilities for that third hike before year-end rather than boost the odds on a March move. ***
*** That said, beyond June, the FOMC is clearly presuming fiscal and tax policy will increase aggregate demand, while a lessening of financial sector regulatory burdens could loosen the channels of the monetary mechanism, making the current policy stance even more accommodative. Short of a “jolt” to the assumed neutral rate, this could invariably require a more rapid policy tightening in 2018 and 2019, be it through rates or the balance sheet. ***
Reactive, Not Pre-emptive
There has been a lot of discussion in the press and markets on the two versus three rate hikes this year, and whether the Chair is a two or three dotter. But the larger point is more straightforward, notwithstanding the interpretations of the rate dot plots.
The FOMC is certainly feeling more confident about the economic outlook, albeit one with a low trend growth that only accents the need to keep an eye on inflation and inflation expectations. But for now, this year’s rate outlook is all about the anticipated pace of rate normalization needed relative to having essentially achieved the twin mandates for maximum employment and nearing the 2% symmetrical inflation target.
The FOMC, then, is for now adopting a reactive posture in its rate stance, and there is unlikely to be a more pre-emptive move bracing against a fiscal boost to aggregate demand until there is clarity on the “timing, composition, and scale” of the changes to fiscal and tax policy. And that is unlikely before the June FOMC meeting. And further arguing for caution in the reaction to fiscal policy, the policy process under a President Trump promises to be more unpredictable than usual.
Furthermore, our sense is that the Fed is also still seeing something of a sequential effect in the Trump Administration’s policy impact on the economy. The post-election burst of “animal spirits” notwithstanding, there is an assumption most companies will wait to see how the changes in tax policy affect their business, which may delay increases in capital expenditures. So the expected kick in real economy spending may come far slower than the anticipatory boost in equity prices, while the stronger dollar and higher bond yields will act as a nearer term restraint on growth.
With that in mind, our sense is that Chair Yellen will also soon begin indicating a shift in the Fed’s emphasis on the labor market and the degree of slack as the important bellwether to the needed level of accommodation to a scrutiny through this year of inflation and inflation expectations to gauge how quickly to remove accommodation.
It is the same cautious, risk-averse approach that has become something of a hallmark of the Yellen leadership, a mirror to her extreme caution against the risk of raising rates too quickly and overstepping an effective equilibrium real interest rate that was falling; only this time the Bayesian risk assessment is the caution in moving too slowly and risking an overshoot that is difficult to reverse without damage to the recovery and the markets both.
In that sense, the Yellen-led FOMC will be in one of those “watchful waiting ” modes that former Chairman Alan Greenspan used to say, but tending towards a hawkish lean in the reaction function to the data. It would suggest the burden of proof will be shifting by summer on those Committee members arguing to take it slower than the two hike base case or against that third hike if inflation looks to be slipping above its projections.
And it is another way of saying that after June, the FOMC will truly be adopting a meeting-to-meeting approach with every meeting truly “live” after all the years of claiming so.
Labor Market and Inflation Dynamics
The hawkish tone to Chair Yellen’s remarks yesterday, and indeed, perhaps underscoring the debate whether she is a three dotter or two, are her long standing views on the labor market and wages, and the dynamics of the inflation process. As the economy nears maximum employment and a near 2% inflation, we suspect Yellen will prove to be as be as much of a tactical hawk as she has been a tactical dove in recent years.
That is more the case since the interplay between the labor market, wages, and inflation look to be unfolding along the lines she laid out in her speeches over recent years. For one, the gradual pace in the normalization of rates has not only brought the Fed closer to the neutral rate by the time of reaching the twin mandates, it has allowed the extended accommodation to further soak up slack around the outer edges of the labor market that last year saw the labor participation rate modestly rise despite the secular downward demographic trends.
One of the core themes to her labor market and monetary policy views is the notion of the “pent-up wage deflation” flip side of downward nominal wage rigidity. Just as wages failed to fall as would be justified in the colossal loss of demand in the 2007-2009 crisis and recession, they have likewise been slow to rise in recovery. The much sought 3% plus wage growth is likely only at the tail end of a tightening labor market — a “high pressure” economy if you will — which is what seems likely through this year, as wages are showing consistent evidence of a pick-up in growth.
Her take on inflation dynamics also seems to be bearing out as well. Unlike many of her more hawkish Committee colleagues who pressed for earlier and more rapid rate hikes for fear of accelerating inflation, Yellen tended to see inflation as more inertial, that once it was pulled down to barely 1% due to the weakness of demand, the fall in oil prices and the stronger dollar, it would tend to persist sideways rather than fall further into outright deflation.
But as the economy slowly recovered, that mostly inertial inflation would only very gradually rise towards its 2% target, lifted by a reawakened Phillips Curve linkage to rising wages in an economy that is 70% services-driven. But under that scenario, it also implies that the inflation once moving through the 2% mark will tend to be resistant to rate restraint, making the “sooner and slower” pace in withdrawing accommodation all the more essential well before the evidence of the upward price pressures became apparent in the data.
And finally, it is worth highlighting that this expectation — that wages could tend to rise more quickly now as the labor market continues to tighten through this year and an inflation whose dynamic may prove hard to restrain — lie at the heart of the reasons Chair Yellen is leaning modestly more hawkish in her expectations for rate policy.