“Regime change” is too strong a term, but we think there may be a subtle shift underway in the Federal Reserve’s near-term reaction function under Chairman Jerome Powell. Coming off his debut chairing of an Federal Open Market Committee meeting only weeks ago, we may get a further glimpse of those nuances in the policy stance when Powell gives his first major speech as chair on the outlook this Friday.
*** Chairman Powell will almost certainly continue to stress a gradual pace in rate hikes and the Fed’s watchful eye on near trends in the labor market and inflation. But he is also likely to accent the uncertainty of the forecasts, due in part to hard-to-model tax cut effects and varying estimates of the fiscal multiplier. More to the point, the Chairman may indicate he is willing to let the data play out over the coming months, in effect, mapping out a more patient, cautious evolution in the Committee consensus that could point to a modestly less hawkish near-term reaction function. ***
*** Indeed, we suspect Chairman Powell is essentially seeking to take full advantage of the policy flexibility built into former Fed Chair Janet Yellen’s “sooner and slower” policy normalization strategy. With the policy rate now so close to its short run neutral level, there is unlikely to be any near-term Committee consensus for signaling a preemptive tightening to counter the risk of an accelerating inflation. Instead a more tempered messaging is likely to lay out a gradualist path with rates more or less kept constant in real terms with growth and a slowly rising short run R* until or unless an inflation surprise changes the developing policy narrative. ***
*** The risks, to be sure, are to the upside. The Chairman could quickly face significant communications challenges if the inflation in goods and services — or asset prices — slips too far ahead of projections. That could become especially problematic if the strength in the labor market is sustained or the gains in the participation rate reverse (another Nonfarm Payrolls is due Friday). Next month, core PCE is expected to jump as last spring’s transitory factors fall out of the year-on-year data. But the potential pay-off, data permitting, could be an eventual boost to a high-pressure economy’s trend growth and a further distancing from the Zero Lower Bound. ***
“Only Decision Taken”
There was a distinctively cautious tone to Chairman Powell’s debut press conference after the FOMC’s March meeting; enough so that it could be taken as a modestly more dovish messaging, especially in his repeated downplaying of the significance to the steepening in the projected rate trajectory in the rate dot plot for the latter years of the current forecasting horizon.
The added hike in 2019 and the “modestly restrictive” 2020 dot plot, which showed all 14 of the FOMC rate dotters marking an end of year fed funds midpoint above their estimates of the longer run neutral rate, was a “highly uncertain” forecast, he noted, adding “I wouldn’t put too much into that.” Powell even at one point asserted there was “only one decision taken ” at the March meeting, which was to raise the policy rate range to 1.5%-1.75%.
That, of course, is not quite true, and while somewhat clumsily put — early days in the messaging learning curve — we believe Chairman Powell was simply trying to play down any sense of a commitment or forward guidance to the rate dot plot. Chair Yellen was often forced to do the same during her years at the helm when the dot plot conflicted with the intended policy messaging. Her efforts to talk down the four-rate hike dot plot for 2016 that accompanied the December 2015 rates lift-off comes to mind, especially in light of renewed geopolitical tensions over trade in recent weeks.
Indeed, the steeper median for the appropriate policy path in 2019 and 2020 would have been hard not to notice, but our sense of the March meeting takeaway was primarily focused on what is likely to be a staggered fiscal impact on the Fed’s growth projections through at least June, if not September, and the modestly higher upward trend in inflation, best reflected in the first ever overshoot in the median core PCE projections as early as next year (see SGH 3/21/18, “Fed: Middle Ground”).
In other words, the Fed staff were uncertain enough over how and to what extent to incorporate the coming fiscal stimulus of the tax cuts and the two-year boost to federal spending that the fiscal effects are likely to come in stages as more information comes in, which will become evident in the June Summary of Economic Projections.
As John Williams, the San Francisco Fed President soon to succeed Bill Dudley at the New York Fed, put it in remarks prior to the March meeting, some of the tax cut effects are hard to model due to among other things, the scale of capital repatriation or the capital pass-throughs.
While the general scale of the fiscal stimulus should be creating enough of a “high pressure” economy and an overheating labor market to underpin at long last a rising inflation, the dynamics of the inflation process and the stretched linkage between assumed higher wages and pricing power remains uncertain enough to warrant some patience to see the evidence the near-term data reveal.
In effect, while the inflation trend line is clearly upward, its inertial nature may give the Fed some near term running room on the gradual pace of its rate trajectory to avoid a quickening of the rate hikes into an outright tightening that might snuff out the recovery before any of the potential supply-side effects may gain hold.
Along those lines, it was noteworthy that in his tight 45-minute presser, Chairman Powell made a point to repeat an earlier theme from the second round of his testimonies on Capitol Hill in February, that there is “no sense the US is on the cusp of an acceleration in inflation.”
That, we think, suggests Powell is in effect hoping to take full advantage of the policy flexibility built into his predecessor’s “sooner and slower” policy normalization strategy that lifted the policy rate close to estimates of the short run neutral level despite a mostly dormant inflation.
Letting the Data Play Out
Much has been made, probably too much, of how Powell is not a macro-economist in the way his immediate predecessors were. But there is also something to Powell by training and inclination being less wedded to the Phillips Curve dynamics and slack-based forecasting models.
It is likely, we believe, to translate into a greater willingness to see how the data play out in the coming months rather than staking out an early, more hawkish stance based on the modeled effects of an extended overshoot in trend growth and a sizable undershoot of the longer run unemployment estimates.
On that front, several Committee centrists have already in their remarks since the March meeting picked up on Powell’s skepticism over the rate trajectory of the dot plots, laying out a case for caution in assuming how much fiscal stimulus there will be, or how much and how soon inflation will be picking up.
There is, for instance, an obvious fiscal “bump up” or a “little extra juice” as Atlanta’s Raphael Bostic recently put it, but who added the fiscal effects on policy would not be “immediate” while stressing there is no small amount of uncertainty over its impact on growth. Philadelphia’s Patrick Harker wondered aloud how the changes in federal tax law will impact state-level taxes, perhaps offsetting some of the stimulus from the federal tax cuts and spending boosts.
Taken together, the thrust of Powell’s handling of the March meeting presser, reinforced by supporting remarks of several of the Committee centrists since the meeting, underscores what we think will be a cautious, somewhat more dovish reaction function to the data in the coming months.
With such an evolving policy consensus unlikely to fully come together until mid-year, it is likely to be June or even later before the probabilities in the likely number of rate hikes this year and their eventual terminal point will become a little clearer.
There are, of course, all sorts of upside risks to such a more cautious, restrained response to the upward impact of the fiscal stimulus so late in the current business cycle.
Wage growth that has been “pent-up” for several years as the labor market tightened could be on the virtual cusp of rising far more rapidly, setting in motion elevated expectations for greater pricing power and a rising inflation that may be that much harder to stem or reverse without a hard landing in a quickened pace of rate hikes. This risk lies at the heart of the more hawkish arguments to keep to a steady pace of rate hikes towards an outright tightening of monetary conditions, the sooner the safer.
What’s more, a messaging of patience on rates policy may become that much more challenging as early as next month when last spring’s “idiosyncratic” downward dips in inflation start rolling out of the data. Core PCE is likely to jump back to at least 1.8% if not higher.
An equally large question likewise hangs over the trend in the labor participation rate. The Fed has been pleasantly surprised by the uptick to the participation rate as enough discouraged, long term unemployed, and part time workers were pulled back into an ever tightening labor force to slow the decline in the headline unemployment rate. But such a cyclical development could start to give way this year to the stronger secular downward demographic trend as the baby boomer retire.
That could push the headline unemployment rate even lower, below 3.5% or even less, if the pace of job creation doesn’t slow enough. That is a long way below most Fed estimates of Nairu. Even if the longer run unemployment estimates are ticked down a bit, such a deep undershoot for so many years has rarely, if ever, ended well.
The pay-off, data permitting, to a more restrained rate path in the near term would be to give some running room for a potential, much-prized eventual boost to productivity-enhancing investments and a higher trend growth. It is a real-time experiment in the benefits to a “high pressure” economy that could see the final demise of deflation risk, and a policy rate rising with a rising longer run neutral rate, and with it, that much more distance from the dreaded Zero Lower Bound.
Of course, that would hardly go unnoticed by a White House already proving to be quick to pressure the Fed when the stock market reverses.