It is telling that several Federal Reserve officials, including Chairman Jay Powell, have in recent speeches referenced the seminal remarks by former chairman Alan Greenspan in 2004 on “Risks and Uncertainty in Monetary Policy.” In it, Greenspan first laid out the risk management approach to policy, lamenting that “uncertainty is not just a perverse feature of the monetary policy landscape, it is the defining characteristic of that landscape.”
Fast forward 15 years and multiply by tenfold, with the occasional tweet firestorm thrown into the mix, and it should provide a sense of how the current chair and the Federal Open Market Committee are approaching policy these days.
*** The abrupt twists and turns in US trade, oil-related sanctions, and fiscal policies, each with such a wide variance of potential outcomes – and overlaid across still unresolved internal questions over inflation dynamics, transmission channels, and an elevated role of financial markets — are injecting an almost unprecedented scale of uncertainty and risk into the current monetary policy process. A sense of this policy uncertainty may thread through the FOMC April 30-May 1 meeting Minutes released later today, offering a glimpse, we think, of a Fed determined to steer clear of the current policy volatility by removing rates from the near policy equation. ***
*** We also expect the Minutes to indicate a pretty thin Committee consensus on a “transient” low inflation. A still vocal minority remains concerned over the persistence in low inflation and the risks to inflation expectations. And while the argument for pre-emptive or insurance rate cuts (SGH 4/22/19, “Fed: A Pre-emptive Rate Cut ‘Recalibration’”) is for now blunted, we suspect the FOMC’s “patient pause” and “transient” low inflation messaging has more to do with pushing back against market and White House pricing and pressures for rate cuts to retain control over the policy narrative until the data provide clearer signals on a policy path going forward. ***
*** Our sense, then, is of an FOMC that still sees little near-term grounds for a rate cut, whether to counter weak inflation or to preempt growth weakening effects of trade tariffs. The FOMC is instead determined to stay on hold through at least September if not for longer, in order to steer clear of the policy volatility and avoid a near term policy error, in either direction. Until then, the Fed is likely to position itself to react aggressively to a downside shock and a more lagged response to an upside surprise. On balance, the probabilities seem to modestly lean to the former over the latter before year-end. ***
Those Insurance Cuts
The biggest single focus of the markets on the Minutes in a few hours is clearly going to be how much of a hint there might be for any tilting in the policy stance towards the rate cuts that are so firmly priced into fed funds before year-end.
We are almost certain there will be lengthy discussions of the ongoing conundrum over the persistence in low inflation despite a near full employment economy.
The concern is that if any aspect of the current inflation dynamics is “transient” or “transitory,” it is that it rose at all from its current levels to briefly touch the 2% target at all, and even then, it may prove to be peak inflation after the twin fiscal stimulus of tax cuts and higher spending. If inflation expectations are allowed to drift even a little lower, they may become entrenched with Japan-like difficulties to reverse and lift back higher.
Several influential Board and Committee members began making the case in speeches and remarks for insurance rate cuts in the weeks just before the meeting. What stood out in particular in the line of thinking being previewed was for rate cuts even if growth is not necessarily weakening.
In fact, central to the argument was that the optimal time to make the rate cuts was exactly when growth is not yet weakening, both to preempt the slower growth so it never comes (thus the insurance) and/or as a jolt to expectations on future inflation by edging the policy rate back just below the bottom end of most short run neutral estimates to ensure some additional accommodation in the economy.
While perhaps conceptually graceful, we doubt there will be any indications of a Committee consensus sympathy, much less a clearly signaled tilt towards rate cuts, either to preemptively jolt inflation expectations higher or as insurance against a trade-driven weakening of an economy that is admittedly already expected to be slowing. There seem to be multiple reasons against the insurance rate cut thesis.
For one, there is nothing like a consensus on this reading of the inflation dynamics across the Committee. While it is near universal that the Phillips Curve is very flat and stretched in the lagged effects from a high pressure labor market to higher sustained wages and upward pressure on prices and emboldened pricing power, there remains a still strong sense within the Committee and most staff that as long as growth stays above trend, as is being forecast, inflation is still far more likely to rise than fall or flatline, however inertial and slow moving it has become.
So in that sense, what if the bold insurance move proves to be a policy error? And a second reason for caution that is related to that, and perhaps with worse consequences, what if it doesn’t work? How would the Fed have to adjust and adapt to the damage to its credibility, and God only knows what it would mean in political terms, not to mention potentially and probably excessively inflating financial asset prices in the process.
But the most considerable caution against the idea is that it is simply too radical and risky of a shift in the Fed’s reaction function.
To make a bold preemptive rate move has always required either the solid protective “cover” of weakening growth or a crisis-context: a collapsing dollar and soaring inflation drove former Chair Paul Volcker to make his dramatic departure from the International Monetary Fund meeting in Belgrade in 1979 to come home and announce “monetarism” and sharply higher rates, while former Chair Ben Bernanke led the way to fast rate cuts and emergency extraordinary measures in 2008 to blunt the disaster of the financial crisis; countering a few tenths of a percent in the inflation measures just doesn’t rank in the upper echelons of high alert.
We think at best if the question over the conditions that would warrant a rate cut come into play in the Minutes, the Committee participants will caution how it would have to be preceded with careful communications and that it would be premised on either an even longer persistence of the inflation weakness, certainly to, say, the September FOMC meeting.
Above all, the FOMC would be far more comfortable in weighing rate cuts against accumulating evidence across the data of weakening growth, more likely due to faltering confidence and business investment spending effects of extended trade uncertainty.
Trade Effects That Cut Both Ways
Trade and tariff effects on the economy are also likely to feature prominently across both the staff and participant discussion sections of the Minutes. There is likely to be nothing definitive in terms of drawing out a likely policy response, though, but rather a weighing of the risks and scenarios; indeed the extent of the potential trade effects on growth and inflation have become even more elevated since the May 1 meeting.
The cross currents of trade effects though, like oil prices, cut both ways in slowing growth as business and consumers adjust to the tariff costs but also in stoking stagflation-like higher prices in some sectors of the economy.
In terms of inflationary effects, an increase in tariffs on imported goods would usually be considered a classic case of a one-off change in the price levels but not necessarily triggering a sustained rise in inflation. The Fed could, all else being equal, look “through” it and hold off on a rate response to counter excessive inflation pressures.
But Fed officials would caution that it is premature, if not simplistic, to assume they will or can afford to look past any inflation effects to counter the slowing growth effects as much of the market seems to be assuming. The policy calculation is far more complex.
Importantly, for instance, the Fed could also look through a brief growth stall to the underlying momentum. It will all just depend on which impulse is the bigger and more immediate driver and that can and will only be assessed in scrubbing the data to get past the noise for the underlying signal of the economy’s momentum and adjustments.
There is for sure a potential negative shock in the tariffs if it causes consumers to hesitate or pull in their spending, or for companies to hesitate on investment spending, which would amount to a supply-side growth downside shock and undercutting productivity-enhancing investment spending. That, in turn, could translate into a cap on the assumed increases in trend growth the more optimistic FOMC members are hoping to see.
Capex has indeed been running well under expectations. Assuming continued growth this year and next, and if the FOMC holds to a trend growth assumption of only 1.8%-1.9%, it will become very hard for the Committee to ignore an expected upward pressure on underlying inflation momentum. That, on its face, would be hawkish signal, and could dictate a rate hike response
What’s more, with the economy already essentially at full employment and running above trend, the inflation component becomes a bit more problematic and is being very closely monitored.
For instance, China has been for many years the low cost base for many global companies, setting something of the floor to global supply chain costs, even if it has lost some of its lowest cost standing in competition from Vietnam or elsewhere. So sustained higher costs out of China could be more than a one-off price level change but the start to higher prices by non-Chinese suppliers finally empowered with some pricing muscle to reverse the downward cost pressures of the last decade or more.
What’s more, the price effects of higher tariffs goods from China generally boosts the pricing power of purely domestic producers (US automobile manufacturers like General Motors faced higher steel prices from its purely US suppliers when the Trump Administration was threatening steel tariffs from Canada).
Those second round effects of the higher cost Chinese imports likewise can and invariably will spread to the more purely domestic consumer and retail sectors or other businesses whose goods or services are unaffected by the tariffs, all seeking to pass on higher costs.
While higher tariffs in themselves, all else being equal, would not necessarily mean higher inflation, the Fed will be closely monitoring and decomposing the data for evidence of a psychological “tipping point” in the coming months in which the higher prices start to stick and begin to show up in higher wage demands.
That, of course, still begs the question of whether the Fed would shrug off or even welcome a bit of a tariff-push to inflation and inflation expectations. But that in fact only draws the rates policy question back into the prolonged internal debate over the nature of inflation dynamics.
And that, because it will not be resolved any time soon and certainty not before September, and barring a shock of some scale, in either direction, points an extended period of cautious patience on rates, despite the enormous disconnect between the Fed’s messaging and the market pricing.