Fed speakers continue to reiterate that policy remains on a gradual path of tightening. So far, the inflation data and brightening economy has more emboldened their commitment to gradual rate hikes than a faster pace of hikes. What about fiscal policy? That train has left the station, but central bankers don’t seem too concerned – yet.
Federal Reserve Governor and Vice Chairman for Supervision Randal Quarles today gave a short speech on the economic outlook and associated policy implications. He praises low unemployment:
After peaking at 10 percent in October 2009, the unemployment rate fell rather steadily to 4.1 percent in January–the lowest level, outside of a period from 1999 to 2000, since the 1960s. Job gains in recent months have continued at a pace that would be pushing the unemployment rate even lower if the labor participation rate had not stabilized in recent years, a welcome development and a sign that the strength of the labor market is pulling in or retaining workers who might otherwise be on the sidelines.
This is a fairly optimistic take – as long as the economy continues to draw in workers at a faster than expected pace, unemployment can stay low despite solid job growth and without inflationary pressure. This is dovish; the Fed doesn’t need to accelerate the pace of rate hikes in this environment. Still, Quarles views activity as close to full employment:
Broader measures of labor market slack–for example, those that include individuals who are out of the labor force but say they want a job as well as those working with a part-time job but who would like to work full time–have largely returned to pre-crisis levels.
The economy is thus running near full employment but with enough new labor supply coming online to prevent overheating. This is something of a Goldilocks scenario. As far the broader economy is concerned:
While the labor market has shown steady improvement over the past decade, the post-crisis performance of gross domestic product (GDP) growth has been more disappointing, averaging just 2 percent per year over the past seven years.
Yes, it has been disappointing. That said, I think this overstates the disappointment. It was sufficient, for example, to push the economy into a place where the Fed could begin normalizing policy. And to drive those labor market gains praised by Quarles. And there were some pretty good periods within that ten years. Still, that is history. For Quarles, all is good now:
However, beginning with the second quarter of last year, growth has shown some momentum. Over the past three quarters of 2017, real GDP increased at an average rate of almost 3 percent. While headline growth stepped back a bit in the fourth quarter, largely on account of increased drag from higher imports and lower inventories, underlying final private domestic demand–which is a better indicator of economic momentum–grew at its fastest pace in more than three years.
Well, is this growth sustainable? Quarles says yes, it is:
The tax and fiscal packages passed in recent months could help sustain the economy’s momentum in part by increasing demand, and also possibly by boosting the potential capacity of the economy by encouraging investment and supporting labor force participation.
Notice the modifiers – the fiscal stimulus “could” help sustain the momentum. That suggests an unwillingness to commit to a sizable boost in the forecast. And even if there is a demand boost, that might be matched with a supply side boost.
This is a “run the economy hot” story. Interestingly, he goes a step further:
Regardless, given the importance of productivity growth for the long-run potential of the economy and living standards, it is vitally important that policymakers pursue policies aimed at boosting the growth rate of productivity.
That isn’t just a job for fiscal policymakers, it is for all policymakers. So here is one way to read this: Fiscal policymakers have done their part with tax cuts for corporations. Monetary policymakers need to do their part by not undercutting growth too quickly. Hence, policy can remain on the current path:
Against this economic backdrop, with a strong labor market and likely only temporary softness in inflation, I view it as appropriate that monetary policy should continue to be gradually normalized.
I think this is not a bad experiment to run. If the Fed wants to see what happens if you run the economy hot, best to give it a try in a low inflation, well-anchored inflation expectations environment. If the economy overheats and sends inflation to 3 percent, it wouldn’t be something the Fed couldn’t control. I am willing to endorse that experiment.
That said, I do find it interesting that Trump’s appointee quickly lands on a story that just happens to undermine the monetary offset story. If you want to run a late-cycle fiscal stimulus, you need a Fed that is on board with that policy. If this is an indicator, Trump’s appointees will lean to the dovish side of policy.
As usual, his outlook is data dependent.
Atlanta Federal Reserve President Raphael Bostic also struck a dovish tone:
Should the recent data unfold in a manner similar to my outlook, I am comfortable continuing with a slow removal of policy accommodation. However, I would caution that that doesn’t necessarily mean as many as three or four moves per year.
Recent evidence suggests that the interest rate that would prevail when GDP and inflation are back on target could be close to 2 percent at the moment, and may rise only modestly over the medium term.
If this is right, then the current stance of monetary policy is still somewhat accommodative but is approaching a more neutral stance. Finally, it is important to remember that the Fed is also removing accommodation by shrinking its balance sheet.
Bostic is emphasizing that “gradual” isn’t just three or four hikes this year; it could be less, citing a low level of neutral interest rates. And that sounds like the direction he is leaning. In my opinion, he may not be placing sufficient weight on the risk that the neutral rate is already moving higher. But his opinion is of course the more important one – he is the FOMC voter this year.
St. Louis Federal Reserve President James Bullard threw cold water on expectations for four rate hikes:
Hiking rates by a total of 1 percent this year, which would signal four increases of the typical 0.25 percent, would be “priced for perfection,” Bullard said.
“The idea that we need to go 100 basis points in 2018, that seems like a lot to me,” he said. “Everything would have to go just right. The economy would have to surprise on the upside a bunch of times during the year. I’m not sure that’s a good way to think about 2018.”
I am wary of placing too much weight on Bullard’s sentiment. The St. Louis Fed’s economic model colors Bullard’s outlook. That model is an outlier approach within the Fed, hence not particular insightful for understanding the likely direction of monetary policy. Basically, everyone is more hawkish than Bullard. That said, he obviously isn’t trying to pull the FOMC to a more aggressive rate path.
Bottom Line: Fed speakers continue to show no urgency to accelerate the pace of rate hikes despite firming inflation data and budget-busting fiscal stimulus. Also, keep an eye out for the possibility that Trump’s appointees reveal themselves to be doves in hawks’ clothing.