With the approach of the Federal Open Market Committee’s September meeting next week, we would highlight four likely takeaways, along with our sense of the backstory to two key themes that seem to be driving a Committee majority consensus modestly more hawkish amid a rock solid economic outlook:
*** A rate hike to 2% to 2.25% fed funds range is all but certain, and we think it nearly as certain the 2018 median rate dot plot will remain at four, reaffirming a Committee tilt to a fourth hike this year in December. Very modest upward tweaks to the growth outlook may also be evident, at least in the full ranges, while the median NAIRU estimate could dip to 4.4%. Trend growth is likely to remain unchanged, the same with the median inflation projections. ***
*** While it could be a close debate, on balance, we suspect the FOMC is more likely than not to jettison the key “accommodative” sentence from the statement. If it does, however, we suspect Fed Chairman Jerome Powell will assert in his post-meeting press conference that it was more to underscore a lack of precision in estimating whether policy is at neutral level rather than a dovish signal the Committee no longer believes policy is accommodative. ***
*** In a rinse and repeat of his Jackson Hole remarks on a risk management approach, Chairman Powell is likely to message the same continued gradual pace of rate hikes and that, beyond September, the timing to subsequent rate moves will be on a data-driven, meeting-to-meeting basis. He might add, if asked, that every meeting will be “live” next year, affording the Fed the luxury of a tactical caution in balancing policy between moving too slowly or too quickly. ***
*** However cautiously approached, one and probably two more rates hikes after September seems to be a solidifying Committee consensus view on neutral. And while there is a desire to pause for an indefinite period once at neutral, it will depend on a fading fiscal stimulus – which may not pan out as expected (see SGH 9/10/18, “US: Midterms, Trade, and a ‘Fiscal Accelerator'”) – and a still largely inertial inflation. There is also a messaging underway to blend “financial excesses” into the risks to the twin mandates, another sign of the FOMC’s more hawkish tilt going forward. ***
Dovish Threads as Tail Risks
It is only fair to note at the outset that there remains a thread of downside risk concerns still running through the Committee, articulated mostly by the dovish minority of members but nevertheless shared by their more hawkish colleagues: the uncertain trade effects on both growth and inflation; spillover risks from the Emerging Markets and China in particular, or an own-goal yield curve inversion with continued rate hikes.
But we think the FOMC majority still see those as tail risks falling outside the base case scenarios for the policy path and that, for now, they would argue toward the timing and length for a potential pause rather than a halt or change in the upward direction of the current rate trajectory projections.
The yield curve inversion calculation, for instance, could stand out in the rate decision come December. If the data are as strong as forecast but inflation is nevertheless as inertial as expected and lacking the upward momentum that would provide the immediate need to hike, all else being equal, the FOMC could opt to pass on a rate hike to reassess its options at the now “live” January meeting only six weeks later.
Unless coupled to softening data or other signs of the economy turning south, in other words, an inversion of the yield curve would not be enough on its own to alter or derail a continued tightening of monetary policy.
The Arc of a More Hawkish Turn
Those dovish threads notwithstanding, our sense is instead of a modestly more hawkish reaction function building among a solid majority of the FOMC. The backstory to that is perhaps best told in two takeaways that came to mind from Board Governor Lael Brainard’s speech in Detroit last week.
The first is more general, namely, the arc of her progression from one of the Committee’s most dovish members to among its most hawkish. In that, her newly articulated views are a useful barometer of where the center of gravity now seems to be within a Committee that is leaning more hawkish amid such muscular data.
Brainard’s progression is more or less right in line with the similar movement among her fellow, former dovish-leaning Committee members, Chicago’s Charlie Evans, and before them, Boston’s Eric Rosengren, and former Chair Janet Yellen, each shifting to an increasingly more hawkish stance as labor market slack shrinks further and the headline unemployment rate falls further below most NAIRU estimates.
The link between tight labor and higher wages may be drawn out — witness the slow rise in wage growth only just now showing any barest signs of stirring — and its assumed upward pressure on inflation is showing an even thinner, stretched linkage, but there remains a base case that an overheated economy will at some point translate into a sustained momentum to the underlying inflation trend.
So while there may be considerable doubts both within and especially outside the Fed system over the assumptions in the Phillips Curve trade-offs as a near policy guide, Brainard’s speech, and similar remarks by Chicago’s Evans around the same time, testifies to the Phillips Curve as a bedrock conceptual framework for a majority of Committee as well as most Fed staff.
Exactly when that underlying upward pressure will be evident in the data is uncertain, but the upside risk is unmistakable.
With the headline unemployment rate nearly a full point below most NAIRU estimates, and core PCE already at mandate-consistent levels, prudence would seemingly confirm the base case policy path Chairman Powell, with a solid Committee consensus behind him, has been mapping out, to maintain the gradual pace of continued rate hikes, albeit after next week, with a careful eye on what story the data are telling to provide a more informed narrative than a reliance on modeled projections alone.
The need for a more data-driven approach is due to the expected cross winds swirling the clouds across the economic horizon in the coming policy period (SGH 8/20/18, “Fed: Jackson Hole, For Now”), and amid the navigational difficulties Powell described in Jackson Hole, a cautionary, tactical approach to the probing for a neutral policy rate. But the direction is still upward.
A New Twist to the Neutral Debate
The second aspect to Brainard’s speech that got our attention was her twist on the great debate over neutral, and in particular, her variation on the theme first laid out by former Chair Yellen in her carefully constructed case at the time for the “sooner and slower” rates normalization.
Yellen, from her earliest days as Chair, made a point to distinguish between a cyclically-driven short run r*that lagged lower than the estimates for the longer run neutral policy rate released in the quarterly rate dot plots. And until it was dropped from the statement in June, that rates may need to run run below neutral for some time was one of the dovish signals inserted into the statement ever since March 2014.
Policy would remain accommodative even as rates were increased, but as the economy steadily recovered and the financial plumbing became more unclogged, the short run r* would be slowly rising towards the estimated longer run neutral.
But as the Fed edged the policy rate closer to a neutral level this year, most FOMC members in fact dropped the fine line of distinction between short run and long run r*, converging on a common estimate of a 2.5%-3% r* nominal range, with an assumption the short run r* is more or less rising to those levels in due course. In some sense, then, the distinction between a lower short run and longer run r* helped to tell the story of why rates were being increased “sooner and slower,” but once at its final chapters, that narrative has lost its efficacy.
Brainard, however, stands out in still embracing the short run r* distinction, and what’s more, to argue that it is not only rising as presumed, but it is rising so quickly on the mighty tailwinds of the the fiscal stimulus that the policy rate may need to be lifted above the longer run neutral estimates just to stay at a true neutral level.
In addition, if the Fed’s base case for an inertial inflation proves to be wrong and inflation is in fact accelerating in a non-linear Phillips Curve outcome, she takes that one step further to argue the FOMC may need to hike even higher and more quickly than currently plotted out in the Summary of Economic Projections and the rate dots.
In effect, the previously dovish Brainard is now making the case for, at minimum, the continued gradual pace in rate increases and no longer hinting at a desirable pause in the trajectory, but it now putting a marker down to positioning the Fed for an even more hawkish policy path, if necessary.
Financial Excesses, Not Just Inflation
None of that, of course, may ever prove to be necessary. But it is a short hop from there to another theme Brainard touched on, and which has been a more frequent concern cited by several other FOMC members in recent weeks, that the risks in an overheating economy is not just in an excessive overshoot of the employment mandate or the 2% inflation target, but in “financial excesses.”
It was in fact a phrase that leapt out in Powell’s Jackson Hole speech, and along those same lines, barely two weeks after Jackson Hole, a paper was presented at a Boston Fed conference on the consequences of a long period of low rates that argued estimates of the neutral rate should incorporate the financial cycle that, in effect, would push neutral to a higher level than currently being estimated.
Those arguments by Claudio Borio of the Bank for International Settlements and Piti Disyatat of the Central Bank of Thailand are not widely shared by most FOMC members or Fed staff. But their arguments about neutral nevertheless neatly fit within the frame of the recent messaging about financial stability that we suspect is likely to become more frequent through the remainder of this year and early next.
Just last week, for instance, Boston’s Rosengren drew an explicit link between an “overshoot” in the employment target so far below NAIRU to an “overshoot” in financial asset prices, with both stoked by a too accommodative monetary policy undershooting neutral, and in doing so, elevating the risk of recession.
Indeed, as Powell has noted several times in the not too distant past, it was financial excess, not inflation, that was the cause to the last two recessions, including the shattering collapse of demand in the 2008 Great Financial Crisis.
Only yesterday, in another sign of the Chairman’s attention on financial stability risk, indications are that President Trump will nominate Nellie Liang, a former senior Fed official who created and oversaw the Board’s financial stability division for several years, to one of the vacant Board of Governor positions. The nomination almost certainly stemmed from a request by Powell, and her likely confirmation will bolster the Fed’s intellectual firepower on financial stability going forward.