As the Federal Reserve prepares to hike interest rates at this week’s Open-Market Committee meeting, market participants are bidding up short-term rates — moving toward the Fed expectations of more increases in 2018. That move could continue when the central bank reaffirms its commitment to further tightening next year.
The FOMC meeting next week is anticipated to end with a rate hike. Indeed, this is for all intents and purpuses already a done deal. The employment report won’t change it. But the employment report could either add or subtract to FOMC concerns that the pace of activity remains sufficient to push the economy toward overheating sooner than later. The consensus forecast reasonably expects an outcome that leans toward the former, with job gains well above that necessary to hold the unemployment rate constant. That outcome would leave the Fed committed to their inflation forecast and hence inclined to maintain their projected policy path.
The consensus forecast expects a nonfarm payroll gain of 190k in a range of 153k to 250k. This strikes me as a reasonable expectation consistent with my forecast:Market participants anticipate the unemployment rate holds constant at 4.1%, with a range of 4.0%-4.3%. To be sure, a decline in the unemployment rate would deepen overheating concerns on Constitution Ave. But I would not expect those concerns to ease much if unemployment stayed constant or even rose given the pace of job growth. Given the Fed’s view of labor force growth, they will expect that a payroll gain near the consensus indicates continued downward pressure on unemployment:Until job growth slows to something close to 100k a month, the Fed will anticipate further unemployment declines. Hence why it would be much easier for policymakers to use the weak inflation numbers as reason to pause if job growth looked to be trending much lower on a sustainable basis. But if anything the opposite is true – the economy appears to have some considerable momentum behinds it and is likely to rack up a third consecutive quarter of 3+% growth as the year ends. This suggest continued demand for labor.
A pickup in wage growth would heighten Fed confidence that the economy is indeed operating at full employment. Wall Street expects wage growth of 0.3% for the month, in a range of 0.1%-0.4%. This translates into a range of 2.5%-2.8% compared to a year ago, putting it potentially at the higher end of recent trends:
Obviously, the Fed would like to see something on the higher end to help confirm their estimates of full employment. But even if they don’t get higher wages, they will anticipate wages gains will eventually accelerate as long as unemployment is poised to remain on a downward trend.
Bottom Line: The Fed would have an easier time paying attention to the weak inflation numbers if the economy has not operating near their estimates of full employment and clearly growing at a pace that will soon surpass those estimates. Consequently, a report near consensus expectations will tend to strengthen their resolve regarding further rate hikes. A report that falls short of consensus, however, would likely be deemed as noise given the generally solid path of economic activity this year.
Thinking about the path of policy next year, this quote from Chicago Federal Reserve President Charles Evans (via the New York Times), seems like an important issue:
I think the economy is doing very well. I think it continues to show strength. The second half is looking like very good growth: 2.5 to 3 percent growth. And this is to be measured against our assessment that sustainable growth is more like 1.75 percent. So 2.5 to 3 percent is very strong growth, which should continue to lead to improved labor market activity.
Unless something structural improves to increase trend growth, we’re going to be decelerating to something under 2 percent — and that will still be a pretty good economic picture.
On the surface, this is a fairly straightforward analysis. The supply side of the economy currently grows at roughly 1.75 percent. The demand side is growing at 2.5-3 percent. So it must be true that activity slows to something under 2 percent.
Indeed, this basic story forms the backbone of monetary policy decisions. Essentially, the economy currently operates at or near full employment, the current pace of activity will take the economy well beyond full employment, and thus the economy must slow to prevent overheating.
The question I have is what does Evans believe triggers this slowdown? That question gets at the heart of the interest rate forecasts for 2018. Does this slowdown occur endogenously as the result of the economy running up against supply-side constraints? Or is it the lagged response of past monetary tightening? Or is further monetary tightening required to restrain growth?
If your answer is either of the first two choices, you feel little need to raise interest rates in December, especially with inflation running soft. Evans appears to be leaning toward the second option:
I think our policy moves to date have been thoughtful and reasonable. We’ve increased our funds rate objective by 100 basis points. Maybe it’s time to stop and see whether inflation expectations are going to move in line with our 2 percent objective. And if the judgment was that we’re still likely to be underrunning our 2 percent objective, maybe we would stop briefly and assess for more information, maybe wait until mid-2018.
In short, the Fed has already done a lot, growth likely to slow, and inflation is a mystery, so why hike now?
But if your answer is the third option then you believe that the necessary (at least in the Fed’s view) tempering of economic activity will only occur after additional monetary tightening.
In either case you eventually get a slowing of economic activity. But the path of short term rates looks very different. I think the majority of Fed policy makers fall into the third category, and thus are more likely than not to see the solid growth of the past three quarters as a signal that the economy will overheat without the projected additional rate hikes in December (25 basis points) and next year (75 basis points). Which is why I expect that as long as the economy looks likely to drive unemployment rate lower, the Fed will remain biased toward hiking rates.
The minutes of the Oct. 31-Nov. 1, 2018 FOMC meeting made a bit of a splash with their mixed message. The minutes revealed widespread concern with the weak inflation numbers of the past year. Yet the minutes also showed that committee members were committed to a December rate hike. Damn the torpedoes, full speed ahead! Why the mixed message? Two words: “gradual” and “lags.”
Before beginning on the Fed, I want to clarify my views on the appropriate path of monetary policy:
- The unemployment rate is likely near or below a point consistent with full employment. The economy currently operates at a pace sufficient to maintain further downward pressure on the unemployment rate.
- The natural rate of unemployment (and, likewise, potential output) is, however, an unobserved variable and as such estimates of its value are subject to nontrivial amounts of uncertainty.
- The low wage growth and low inflation of the past year look inconsistent with an economy operating at full employment.
- The reasons for (3) above may be mis-measurement of the natural rate of unemployment, a change in the inflation-setting mechanism such as declining inflation expectations, or simply the result of lags in the time between reaching full employment and experiencing an impact on wages and inflation.
- Given persistently low inflation, not just this year but also since the recession ended, the appropriate course of action is to delay further rate hikes until we have more clarity on the inflation story.
- Moreover, then tendency of the Fed to error on too high unemployment over too high inflation also argues for caution.
- If rate hikes are delayed now, it is with the understanding that they may need to be adjusted upward quickly in the future or endure a period of above target inflation in a low unemployment environment (central bankers won’t like this).
With that, back to the minutes. Importantly, the concerns about inflation ran deep:
With core inflation readings continuing to surprise on the downside, however, many participants observed that there was some likelihood that inflation might remain below 2 percent for longer than they currently expected, and they discussed possible reasons for the recent shortfall…
…In discussing the implications of these developments, several participants expressed concern that the persistently weak inflation data could lead to a decline in longer-term inflation expectations or may have done so already…
… the possibility was raised that monetary policy actions or communications over the past couple of years, while inflation was below the Committee’s 2 percent objective, may have contributed to a decline in longer-run inflation expectations below a level consistent with that objective. Some other participants, however, noted that measures of inflation expectations had remained stable this year…
This sounds like a fairly bleak discussion which should support a reassessment of the path of rate hikes going forward. With this in mind, central bankers reaffirmed their support for gradualism:
Nearly all participants reaffirmed the view that a gradual approach to increasing the target range was likely to promote the Committee’s objectives of maximum employment and price stability.
But what how gradual is gradual? The split starts to emerge, with one group wanting to slow the pace of rate hikes from gradual to “quite gradual”:
A number of these participants were worried that a decline in longer-term inflation expectations would make it more challenging for the Committee to promote a return of inflation to 2 percent over the medium term. These participants’ concerns were sharpened by the apparently weak responsiveness of inflation to resource utilization and the low level of the neutral interest rate, and such considerations suggested that the removal of policy accommodation should be quite gradual.
Another group remains committed to the current plan:
In contrast, some other participants were concerned about upside risks to inflation in an environment in which the economy had reached full employment and the labor market was projected to tighten further, or about still very accommodative financial conditions. They cautioned that waiting too long to remove accommodation, or removing accommodation too slowly, could result in a substantial overshoot of the maximum sustainable level of employment that would likely be costly to reverse or could lead to increased risks to financial stability. A few of these participants emphasized that the lags in the response of inflation to tightening resource utilization implied that there could be increasing upside risks to inflation as the labor market tightened further.
The second group sees the economy as far too close to full employment to slow the pace of rate hikes. Notably, the phrase “a substantial overshoot of the maximum sustainable level of employment that would likely be costly to reverse” is code for “we don’t want to accelerate the pace of rate hikes later because we think it will cause a recession.” I view this group as thinking that policy cannot become any more gradual without abandoning gradualism.
How will this play out in December? Members remain focused on a rate hike:
Consistent with their expectation that a gradual removal of monetary policy accommodation would be appropriate, many participants thought that another increase in the target range for the federal funds rate was likely to be warranted in the near term if incoming information left the medium-term outlook broadly unchanged.
Of course, everything is data dependent:
Several participants indicated that their decision about whether to increase the target range in the near term would depend importantly on whether the upcoming economic data boosted their confidence that inflation was headed toward the Committee’s objective.
The key here is that the necessary data is not limited to inflation itself; this point may have been lost with the focus on inflation in these minutes. For instance, the data since this meeting indicates economic activity proceeds at a pace that supports continued tightening of labor markets. Most central bankers will interpret this as evidence the economy remains positioned to move further past their definition of full employment. Notably, the unemployment rate is now down to 4.1%, a level the Fed did not expect to see until the end of 2018.
Only a smaller group wants to see more specific evidence that inflation will return to target in a timely fashion:
A few other participants thought that additional policy firming should be deferred until incoming information confirmed that inflation was clearly on a path toward the Committee’s symmetric 2 percent objective.
The challenge facing central bankers is on full display on these minutes. FOMC participants are largely dissatisfied with the inflation readings. So why not just stop hiking rates? Because when assessing policy, they need to take into account the state of the labor market (or, more generally, the overall economy). And while there is uncertainty in what exactly constitutes full employment, no one on the FOMC believes that the unemployment rate can fall to 0% before the economy overheats. Indeed, I doubt that anyone on the FOMC believes that 3% would be sustainable.
Moreover, I don’t think that there is widespread belief that the Fed can accelerate the pace of rate increases at a later time without triggering a recession. Essentially, given lags in the economy, once inflation becomes visible, the unemployment rate would already be too low to easily push the economy back up to full employment. In this view, recession is almost certain, not without justification – their track record on this point is not great. Consequently, when faced with the stench of the inflation numbers, most policymakers remain willing to just pinch their noses and continue to tighten policy. They are not yet ready to slow the pace of rate hikes, which is why December looks like a done deal.
Will the group looking to slow the pace of rate hikes soon take control? It seems like that should happen by early 2018 if inflation remains mired below target. A reassessment of the estimate of the Fed’s terminal rate could help the Fed maintain its commitment to gradualism while slowing the pace of tightening. The stickiness of the long end of the yield curve may force FOMC members to lower their estimates of the longer run interest rate, thus allowing for the Fed to ease pace of tightening while mitigating the risk they will need to raise rates sharply to get to neutral – rapid hikes wouldn’t be needed because they would already be closer to neutral!
That said, I am somewhat wary of embracing this scenario. It would be consistent with my existing priors of the correct path for policy, and I don’t want to error by projecting that view on the Fed. I don’t know that they will really back down when unemployment drops below 4%, which I think is likely in short order. It would be much easier to envision the Fed taking an extended pause from rate hikes if economic activity slowed markedly and pulled monthly job growth to something closer to 100k. (That said, I think that lags could also be important here; just as the impact of tight labor markets may not have hit inflation, the impact of tighter monetary policy may not have hit job growth.)
Moreover, watch the FOMC churn here. I suspect at least three 2018 voting members – Dudley (for first half of 2018), Williams, and Mester – are not willing to take that risk. These voters take on more significance in the context of an understaffed Board of Governors. I am currently challenged to see them backing down until job growth slows and unemployment stabilizes, and I can see them throwing around their intellectual weight.
Bottom Line: The squeeze on the Fed only intensifies. Should they ease the pace of rate hikes now on the inflation outlook, or is that countered by the falling unemployment rate? If the unemployment rate was a percentage point higher, they would slow the pace of rate hikes. If job growth slowed such that they could credibly believe that the unemployment rate would stabilize, they would slow the pace of hikes. But if the unemployment rate remains poised to fall further from current levels? That’s a much more difficult choice, one that hits on the core principle of “gradualism” that guides policy. They risk facing a faster pace of rates hikes later if they back down now, and that risk only grows the lower unemployment falls. The way out of out for the Fed: A lower estimate of the neutral policy rate.
It was supposed to be easy. When the Federal Reserve started hiking the federal funds rate, longer-term interest rates would rise. After all, they were at very low levels, restrained by a low-term premium. The “Greenspan conundrum” of the past two cycles, when long rates failed to respond in line with higher short rates, couldn’t happen a third time in such circumstances.
But it didn’t work out that way….
Incoming data indicate the US economy retains momentum as 2017 draws to a close, clearing the way for the Fed to hike rates in December. Inflation, however, remains on the soft side and continues to make some FOMC members nervous. That said, the consensus looks set to downplay those concerns amid an environment of solid economic growth and declining unemployment rates. I think it will be a challenge for FOMC members to shift gears to steady policy until growth moderates sufficiently to stabilize unemployment rates.
At some point every year I sense a need to reset and clarify my baseline views on the economy and monetary policy. This is that time.
Lots of news from last week, most of which supported the Fed’s current anticipated rate path of one 25bp hike in December followed by three more in 2018. The only potential obstacle on that path is the persistent weakness of inflation. But the ongoing decline in the unemployment rate, along with the promise of further declines in the months ahead, will dominate lingering concerns at the Fed regarding the inflation numbers.
The U.S. appears set to enter a more risky phase of the business cycle as the Federal Reserve attempts to glide the economy into a so-called soft-landing. For President Donald Trump’s likely nominee as chair, Jerome Powell, this means tightening policy enough to settle the economy into full employment, but not so much that it trips into recession.
Navigating this transition will be challenging for investors and the Fed alike. Market participants should be wary of assuming that a slowing economy means a recession is near. At the same time, central bankers need to be wary that they don’t slow the economy too much and set the stage for the next recession. Altogether, this means the relative calm of the past year is likely to end soon.
Updated: Jerome Powell was nominated to serve as Fed Chair as expected.
Central bankers will meet this week, but only to sign off on the existing policy stance. Although it pains this fedwatcher to admit, the FOMC meeting is arguably the least important event of the week. It competes with a slew of critical data, including the employment report for October, to be released Friday. Plus, we should learn President Trump’s pick to lead the Fed when Yellen’s term expires next February. An FOMC meeting widely expected to yield no change in policy and likely little in the accompanying statement simply can’t compete with this week’s news flow.
The Fed continues to follow its well-defined strategy of setting policy via balancing solid employment against weak inflation as the economy settles into full employment. This strategy relies on a basic Phillips curve framework that anticipates intensifying inflationary pressures as the unemployment rate falls below its longer run rate. The Fed will see this as a tried and true strategy; they hesitate to abandon it on the basis of what they view as short-term inflation shortfalls.
Following this strategy, I anticipate the Fed will continue to pursue the current projected path of policy as long as job growth remains strong enough to push unemployment lower. In other words, they are likely to continue to turn their attention away from the disappointment of low inflation in favor of the excitement of labor market gains.
In practical terms, this means that emphasis on rate hikes will remain as long as the economy looks set to support job growth of more than 100k a month. The third quarter GDP report will confirm their suspicions that this continues to be the case. GDP gained at a 3.0% rate in the second quarter after gaining at a 3.1% rate the previous quarter. This is the strongest back-to-back growth since 2014. Compared to a year ago, the growth was more subdued at a 2.3% gain, albeit still sustaining a trend of steady improvement.
Digging into the numbers, the contributions from investment and net exports rose, while the gains attributable to consumption softened. The Fed will be particularly happy with the investment gains (similarly, they will like the story told by the strong durable goods orders report last week). Investment was a significant factor in the slowdown of 2015 and 2016, and the Fed will be relieved that this wound is healing nicely.
A look at averages over the last four quarters (noise in the quarterly numbers tends to hide underlying trends) reveals that while investment has begun to rebound from the 2015 decline, consumer spending has not. Nor I think should we expect a substantial acceleration in consumer spending at this point in the cycle. More likely is that while wage growth should rise further, the gains will compete with slower overall job growth to constrain spending growth. In other words, these numbers might be about what you might expect as the economy reaches full employment.
The trend in net exports is only a small drag on GDP growth, but this is due to a particularly large negative hit in the third quarter of 2016. Net exports have made a positive contribution in five of the last six quarters. I would have expected a more negative contribution given the acceleration in investment activity, but apparently we need to see a more rapid growth in domestic activity such as from late-2014 to mid-2015 to drive a greater drag from the external sector. And then at least small contribution from government spending supported domestic growth; the government spending contribution has fallen to basically nothing (a small negative in recent quarters).
Note the negative contributions from residential investment the last two quarters. With the multifamily sector likely over its peak for the current cycle, we need more single-family construction to support investment numbers in this sector. And although the trajectory for single-family is in the right direction, the pace of gains remains subdued.
Overall these are numbers that will continue to add jobs at a pace sufficient to push down unemployment. Indeed, the pace of growth remains too rapid given current projections of productivity and labor force growth. Consequently, the Fed anticipates that growth needs to slow to maintain balance in the economy, and will be focused on tightening policy further to ensure that slower growth emerges. This is an environment that looks ripe for an acceleration in the pace of rate hikes should fiscal policymakers push through a substantial tax cut that stimulates domestic demand.
As an aside, I can’t shake the feeling that the current pattern of growth remains very finely balanced, almost too balanced, as if it were ripe for a change.
The selection of the next Fed chair devolved into a reality TV show. Even the losers are announced first; supposedly Gary Cohn is out of the running. So too are current chair Janet Yellen and former Federal Reserve Governor Kevin Warsh, at least according to the Washington Post. I never held out much hope for a Yellen reappointment on the basis of the politics, but still will be disappointed if she is not retained.
That leaves current Federal Reserve Governor Jerome Powell and Standard economist John Taylor vying for the top spot. Trump reportedly leans toward Powell. This is the smart choice if Trump wants to keep the party going; Powell is likely to retain much of the current policy framework that has worked well. At best I would anticipate a only more slightly hawkish policy lean under Powell, and that would be fully data dependent. A choice of Taylor, however, would likely be more popular with Congressional Republicans. And Trump was reported to be impressed with Taylor.
I don’t think we can rule out the possibility that this season has a surprise ending – a dual nomination of Powell for the chair and Taylor for the vice-chair. To be continued after this commercial break.
On the data side of the story, the week begins with the personal income and outlays report and with it the inflation numbers. Expectations are for a meager 0.1% read on core-PCE inflation. Tuesday brings us the employment cost index, the Case-Shiller home price index, and the beginning of the FOMC meeting. Wednesday brings the ADP job numbers, the ISM manufacturing index, construction spending numbers, and the conclusion of the FOMC meeting. Thursday is third quarter productivity numbers and jobless claims. And Friday are reports on employment, international trade, and the ISM service index. The consensus expects a rebound in nonfarm payroll growth to a whopping 323k after last month’s hurricane-induced negative print.
Bottom Line: A nonstop week from beginning to end. Stage set for lots of excitement outside the FOMC meeting, none in the FOMC meeting. A December rate hike is virtually certain at this point.