Fed: Opening Four

Published on February 28, 2018

If Federal Reserve Chairman Jerome Powell wanted the markets to take his maiden Semi-Annual testimony before the House Financial Services Committee yesterday as a first foray towards four rate hikes this year, he got what he was looking for, and then some.

*** More specifically, Chairman Powell’s “personal outlook” reply to the question about the March quarterly Summary of Economic Projections – a listing of a virtual cocktail recipe for an overheating economy — sounded so jarringly bullish, if not outright hawkish that it leapt out from the otherwise more balanced remarks in the rest of the Q&A and the written testimony.‎ At minimum, it felt like a first small step towards a four hike path, and whether intended or not, Chairman Powell in that one response put a four hike market pricing just one or two stronger than expected data points away. ***

*** In the cold, calm of the morning after, however, our sense of the Committee consensus in the run up to the March meeting remains a “three plus” 2018 rate outlook — a base case of three rate hikes, with the option, but not the certainty, of a fourth. We still think the FOMC will be somewhat cautious in moving too soon to a four rate hike scenario, preferring to see how inflation, and perhaps an early indication of investment spending look to be playing out this spring before signaling a fourth rate hike. That would put any upgrade in the pace of hikes this year more likely still into the June meeting. ***

*** We likewise believe the 2018 median in the March rate dot plot will stay at three hikes, but barely‎. It may not matter, though, since enough of the 15 rate dot projections seem likely to migrate north by then that a “hard four” lean will be unmistakable, especially when framed against Chairman Powell’s hawkish “personal outlook” remark. Unless the Chairman opts to use his testimony tomorrow before the Senate Banking Committee to soften the impression he created, the Fed may have to scramble on the communications front to convince the markets an increasing lean towards four is still gradualist, and not moving towards a more accelerated pace in rates normalization. ***

A Personal Outlook

Chairman Powell for the most part carefully hued his answers in his testimony before House Financial Services to reflect the wider consensus of the Federal Open Market Committee, phrasing the greater confidence in the economic outlook with made to be quoted phrasing in the written testimony with lines like “some of the headwinds the U.S. economy faced in previous years have turned into tailwinds.”

But his reply to the always incisive questions from New York Democrat Carolyn Maloney leapt out from the more balanced remarks in the rest of the Q&A or his written testimony.‎

When specifically asked about the March SEP rate dot plot, he offered that his own individual rate dot would be based on his “personal outlook” that the economy “has strengthened since December,” and that while he would not want to “pre-judge” the other dot plotters, he then listed what sounded like a virtual cocktail mix for an overheating economy: “continuing strength in the labor market, signs inflation is moving up to target, better global growth and more stimulative fiscal policy.”

Whether intended or not, his answer seemed to go well beyond merely wanting to make sure the markets understood the Fed could, if needed, hike four times this year, a modest uptick in the pace from last year’s three hikes.

For context, there is an awful lot of fiscal stimulus about to swell aggregate demand and growth this year and next, and while Fed staff are only just starting to build their forecasts for the March meeting, the median projection for real growth may reach as high as 2.8%, or a full point over trend. That would be pretty hard for the FOMC to ignore when it comes to rate projections, with the risk otherwise of seeing their central bank union card being pulled.

In any case, the recent data coupled with the thrust of Chairman Powell’s “personal outlook” remarks in the testimony‎ have all but taken a two hike in 2018 scenario off the table, while the odds on an eventual four hike 2018 have no doubt risen, perhaps substantially, probably better than even if the data continues to be strong — and on the score, the Nonfarm Payroll breakdown next week is taking on an outsized significance.

Gradualist Messaging Strained

While the markets after an initial shock sell-off seem to have taken it in stride, we suspect a rates messaging that feels pre-emptive could nevertheless strain the Fed’s ability to control its gradualist messaging if his remark is left alone, much less if there is a doubling down in the Senate testimony tomorrow.

The market, for instance, could go on alert for an even more hawkish Fed, pricing beyond four on every data point that comes in a bit stronger than expected in the months ahead. That could especially prove to be the case if the inflation prints show, as expected, an uptick this spring when last year’s “transitory” downward pressures drop out of the year-on-year data.

So we wonder whether the Fed will want to be a bit more cautious in the sequencing of its rates messaging, if that is the right way to describe it, as it is far easier transmission into the markets to modestly upgrade the economic and rates outlook as the data come in than it is go too soon to a more hawkish stance and then backpedal if the data should even modestly disappoint.

And while we noted that dovish sentiments had for the most part been virtually swept away in the high tide of fiscal stimulus (see SGH 2/20/18, “Fed: The Powell Messaging”), we think there remains a core of dovish caution across the Committee: after all these years of undershooting the inflation mandate, the Fed cannot be certain of the long-expected rising inflation until probably mid-year.

By then, the Fed should get a clearer sense of the evidence whether the more fundamental, labor market-driven upward pressures on prices are indeed gathering momentum beyond the transitory factors of last year dropping out of the data.

And while there is no reason to doubt the link in the forecasting models between wages and eventual cost pressures, it is nevertheless a weak one and the time frame is highly uncertain, certainly in the hand-off in higher broad-based wage growth translating into corporate pricing power.

Likewise, some FOMC members caution it will still take time to fully understand the effects of the tax cuts, whether they will indeed lead to higher investment and eventual productivity gains, or whether the tax cuts could, for instance, be used to absorb higher labor costs without trying to pass on any higher wage costs through higher prices.

It will, in any case, be a delicate messaging balancing act for the new Chairman in the next few months and not just in tomorrow’s second round of testimony.  Fed officials are painfully aware that the balance they are seeking in the policy path between an overheating economy and nudging inflation up to mandate-consistent levels crucially first requires an equal balance in their policy signals.

Ensuring a smooth transmission of the intended monetary policy into the real economy while at the same time containing speculative or excess reactions in the financial economy that could slow the economy’s solid momentum too soon by too much could prove to be no mean feat.

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