Anxieties over how the Federal Reserve might respond to a newfound inflation threat and stock market gyrations are putting a communications premium on the first public remarks of Fed Chairman Jerome Powell when he testifies before the House Financial Services Committee in his first Semi-Annual Monetary Policy Report on February 28.
Indeed, Fed officials see managing market expectations in the coming months the greater policy challenge than inflationary pressures in the real economy.
*** The enormous stimulus from the tax cuts and the two-year budget deal is putting considerable strain on the rates normalization policy so carefully crafted by departing Chair Janet Yellen. Dovish sentiments within the FOMC have essentially been swept aside in the rising tide of front-loaded demand stimulus and near certain mark-ups to growth and new upward inflation pressures. The FOMC consensus has solidified around a base case of three rate hikes this year with a fourth possible, if not probable. Further out, more of the Committee see rates rising above the median longer run neutral estimate, which itself may be rising through this year, mirroring a near neutral rate rising more rapidly this year than previously assumed. ***
*** A clearly hawkish thread will run through Chairman Powell’s testimony next week when he is likely to stress policy continuity in a gradual pace of further rate hikes, and a close eye on financial stability. But it could be a tricky balancing act in messaging for the new, untested Chairman: he will labor to avoid even a whiff of baby-sitting a wobbly stock market with a “Powell put” readiness to intervene, but he will be equally forceful in affirming the Fed will not rush to raise rates against what it believes will be a rising but hardly accelerationist inflation. To guard against a redux of the 2013 messaging misfire with a “taper tantrum” like spike in yields, the potential fourth rate hike this year will be repeatedly messaged as still gradual rather a change in the policy stance. ***
*** Looking ahead to March, a rate hike is all but certain along with hawkish tweaks to the statement. Growth will be marked up, perhaps substantially, though it may more likely come in stages in the March and June projections. But as the Committee consensus currently stands, we think, on balance, the March median rate dot projection is still more likely than not to stay at three rate hikes this year rather than edge up to four, despite upward drift in the rate projections. A fourth hike this year would come into view by mid-year when there is expected to be greater clarity on inflation dynamics, the evolution of R*, and how the fiscal stimulus is playing out. That would, in turn, give the markets more time to adjust to the Fed’s base case rate path. ***
A “Further” Confidence
The Minutes to the January FOMC meeting will be released tomorrow afternoon, and will serve as something of a bridge from the December meeting hike and rate dot projections to Powell’s testimony, and on to setting up the expectations for the March FOMC meeting.
The key signaling of the January statement was of course the inclusion, twice, of the “further” in the descriptions of the gradual adjustments and increases in the rate path. As we wrote after the meeting (see SGH 1/31/18, “Fed: Further”), we thought the overall tweaks to the wording of the statement were meant to frame market expectations for Fed policy with a clear hawkish tilt, but to still carve out some policy flexibility in the near term.
More specifically, the discussions in the Minutes are likely to make it clear the “further” inclusion was indeed meant to be modestly more hawkish in signaling the Committee confidence in the resilience of the recovery and in the Fed’s base case three hike median rate path this year. The Minutes may hint as well what is essentially an equal degree of confidence in the likelihood of a continued upward trajectory in rates towards and perhaps beyond the longer run neutral levels — a reminder, in other words, that there is no “one or two more hikes and done” scenario in the FOMC’s current rate outlook.
In the same line of thinking, the Committee is very likely to have reviewed their estimates of the near R* and what the Minutes may indicate is a wider belief within the Committee that the combination of (then) still easy financial conditions, a weaker dollar, rising consumer and business confidence and above all the fiscal boost to aggregate demand, that the effective R* could be rising more rapidly this year than previously assumed.
What may have been an effective real equilibrium rate of 0% to perhaps no more than a half point above is now perhaps on the rise, certainly to the 0.5% top end of the previous estimates, and maybe higher; the Fed, in other words, may be needing to lift rates this year to 2-2.25% just to keep avoid falling behind in the gradual removal of monetary accommodation.
Likewise, the Committee’s estimates of the longer run neutral nominal rate, which had been lurching down in spasms since 2016 from north of 4% to barely 2.8% in December, may soon be edging back north towards 3% in the Summary of Economic Projections through this year.
Along with it, the consensus views on the inflation dynamic may be starting to change due to the sheer scale of fiscal stimulus to aggregate demand. The fiscal multiplier in the spending surge over the next two years mapped out in the early February budget deal on Capitol Hill is substantially higher than that of tax cuts in most of the Fed forecasting models, and so is being treated quite differently than the tax cuts.
Demise of Dovish Caution
That sense of a fiscal game changer to the inflation dynamics during and certainly in the weeks since the January meeting may, in some sense, mark the demise of dovish caution on the base case rate path inside the FOMC.
Essentially gone are the previous concerns for the downside risks in a continued course of rate tightenings until there is clearer evidence of firming inflationary pressures, and slipping into the back pages of the policy narrative are the concerns for inflation expectations at risk of declining, while the once flattened, nearly comatose Phillips Curve is being viewed in a new light, likely to be very much alive after all, and perhaps soon showing its steepening hand in the data before too much longer.
If truth be told, the cascade of fiscally-driven aggregate demand — in an economy already at above trend growth and below its longer run unemployment levels — is a Godsend of sorts for the Fed as an institution, saving Fed officials from a potentially painful existential introspection of their most basic, slack-based assumptions of how the economy and the inflation process works or in solving the “mystery” of the persistence in low inflation.
It further brings to mind for many Fed officials the research “question” Chair Yellen had suggested in a speech last October when she wondered aloud what the effects on inflation were likely to be of an ever-tightening labor market in a “high pressure” economy: the Fed will soon be addressing exactly that in real time.
In any case, rather than March, it is more likely to be some time into the mid-year that there is likely to be more clarity on the inflation outlook and, in turn, the need for any adjustments to the gradual pace of rate hikes: for one, the transitory “idiosyncratic” downward pressures on prices last spring will have rolled out of the data by then, and the Fed will have a better grasp to what degree higher wage growth is or isn’t finally showing up or translating into greater pricing power or just crimped profit margins.
And even the magnitude of the fiscal and tax stimulus to aggregate demand may still not be all that clear by the March meeting, meanings its eventual impact may have more of a rolling impact in the March and June, maybe September, SEPs rather than one out-sized, blow your shorts off upward revision in March.
A Careful Messaging
Against that backdrop, a clear majority of the FOMC, including its new Chairman, will want the optionality on the table of a potential, perhaps even probable, fourth rate hike this year. But our sense is that Powell and most of his Committee colleagues will not want to signal the fourth rate move as a given in either the testimony — which by the way, is meant to reflect the broad consensus views of the Committee, not the Chairman’s personal views — or we suspect, even at the March meeting. Like St. Augustine, not yet.
That could change obviously if the data between now and March 20-21 FOMC meeting all surprise to the upside. But for now, reflecting the strength of the consensus in the hand-off from Yellen to Powell in January, the base case has solidified around three rate hikes, with a “maybe four” added to most of Committee rhetoric comments since the meeting.
The reason for the dance with a “maybe” four is to message the optionality of that possible fourth hike this year as simply an extension of the gradual pace of the rates normalization underway since the December 2015 rates lift-off.
Fed officials, in other words, will be quite keen to push the market away from seeing the higher likelihood of a fourth rate hike this year as evidence of a change in the Fed’s policy stance to a quickened pace of rate hikes to blunt a rising faster than expected inflation.
Inflation will be, should be, rising at long last this year, but not even the most hawkish members of the FOMC expect any sort of accelerationist inflation that warrants pre-emptive rate hikes. After all, that was the whole point of Yellen’s “sooner and slower” rates normalization strategy despite the persistence of inflation stuck for so long below the 2% symmetrical target.
And no one on the FOMC, certainly not Chairman Powell, wants to see a messaging misfire or a market dislocation in misreading the Fed’s reaction function and most likely pace of rates normalization in the critical months ahead.