The minutes of the January FOMC meeting revealed increasing confidence in the economic outlook. That translated into increased confidence that gradual rate hikes remains the appropriate policy path. Does that mean the central bankers stand poised to raise their “dots” such that the median rate hike projection rises to four hikes? I don’t think so. I read the minutes as wiping away lingering concerns about the inflation outlook and allowing policymakers to coalesce around the existing three hike projection. The risk remains, of course, that conditions remain sufficiently buoyant to raise the rate projection in June or September. More important to me at this juncture is I see clear hints that the projections beyond 2018 are vulnerable to upward revisions.
Remember that the December rate hike was met with two dissentions. That suggests caution among central bankers. Moreover, there were six “dots” below the median projection of three hikes, compared to four above. Again, an indication of overall caution. That caution stemmed from the inflation disappointment in 2017. But this is how participants viewed the economic environment in January:
…A number of participants indicated that they had marked up their forecasts for economic growth in the near term relative to those made for the December meeting in light of the strength of recent data on economic activity in the United States and abroad, continued accommodative financial conditions, and information suggesting that the effects of recently enacted tax changes–while still uncertain–might be somewhat larger in the near term than previously thought. Several others suggested that the upside risks to the near-term outlook for economic activity may have increased. A majority of participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate…
Firming confidence in the pace of economic activity translated directly into confidence in the inflation forecast:
Almost all participants continued to anticipate that inflation would move up to the Committee’s 2 percent objective over the medium term as economic growth remained above trend and the labor market stayed strong; several commented that recent developments had increased their confidence in the outlook for further progress toward the Committee’s 2 percent inflation objective. A couple noted that a step-up in the pace of economic growth could tighten labor market conditions even more than they currently anticipated, posing risks to inflation and financial stability associated with substantially overshooting full employment. However, some participants saw an appreciable risk that inflation would continue to fall short of the Committee’s objective.
For the most part, incoming data strengthened the likelihood that the inflation forecast will be met in 2018. Not exceeded, but met. Of the participants on either side of that bet, the doves (some) appeared to outweigh the hawks (a couple). Hence arguably some caution remains. Still, the overall story is that in January the Fed was ready to declare that gradual rates hikes would indeed continue in 2018:
Members expected that economic conditions would evolve in a manner that would warrant further gradual increases in the federal funds rate. They judged that a gradual approach to raising the target range would sustain the economic expansion and balance the risks to the outlook for inflation and unemployment. Members agreed that the strengthening in the near-term economic outlook increased the likelihood that a gradual upward trajectory of the federal funds rate would be appropriate. They therefore agreed to update the characterization of their expectation for the evolution of the federal funds rate in the postmeeting statement to point to “further gradual increases” while maintaining the target range at the current meeting.
I think there may have been another motivation to add the modifier “further.” The Fed had spent much of 2017 trying to reinforce the three rate hike scenario, a matter made more difficult by the focus of some members on the weak inflation numbers. Taking a modestly firmer stance in January could be interpreted as putting market participants in notice to not underestimate the Fed in 2018.
What has changed since January? Two particularly important events. First is the wage and inflation data. Maybe though that isn’t too important yet – policymakers like San Francisco Fed’s John Williams, Minneapolis Fed’s Neil Kashkari, and Cleveland Fed’s Loretta Mester have all tried to tamp down expectations that the Fed will over react to higher inflation. Remember that last year was a model for how to handle inflation surprises: Keep a focus on the medium term.
The second event is the new fiscal spending plans. Note that participants were already expressing concern that the tax cuts would have a larger impact than they expected. It seems then policy makers will almost certainly see greater upside risk from the additional spending. Where does that fit into the forecast? They have a choice – they can accelerate the pace of gradual by adding a fourth hike in 2018, or up the 2019 forecast from a two-plus-some to a full third hike. I think they go for that latter.
Why put the extra hike in 2019? A few reasons. First, by 2019 the economy will be hit with the full force of the spending, so it seems natural to tighten up a bit more then. Second, I think they will be wary of deviating too much from the “three hikes is gradual story” just yet. Fixed income markets are already primed to over react to any sign the Fed is changing course. It appears central bankers are working to quell such concerns. It will be hard to do so if “gradual” suddenly becomes “faster.” That has taper-tantrum written all over it. Three, it would be the Fed at odds with the White House after Powell’s very first press conference. Equities would take a hit and every financial headline would read something like “Fed Squashes Trump’s Growth Agenda With Faster Rate Hikes.” I think the Fed really needs to be sure about what they are doing before they head down that road. I know, the Fed isn’t supposed to worry about such things. Except in the real world they do.
And one more reason: The Fed could be raising its estimate of the neutral rate. Back to the minutes:
Some participants also commented on the likely evolution of the neutral federal funds rate. By most estimates, the neutral level of the federal funds rate had been very low in recent years, but it was expected to rise slowly over time toward its longer-run level. However, the outlook for the neutral rate was uncertain and would depend on the interplay of a number of forces. For example, the neutral rate, which appeared to have fallen sharply during the Global Financial Crisis when financial headwinds had restrained demand, might move up more than anticipated as the global economy strengthened. Alternatively, the longer-run level of the neutral rate might remain low in the absence of fundamental shifts in trends in productivity, demographics, or the demand for safe assets.
You can view the relative buoyancy of financial conditions – the past few weeks notwithstanding – as an indication that the neutral rate is rising as the wounds of the financial crisis heal. And perhaps more importantly, although the demand for safe assets might still be high, the combined tax cuts and spending increases seem certain to increase the supply of safe assets. This too should put upward pressure on the neutral rate.
If the estimate of the neutral rate rises, then expected policy rates will need to rise as well to ease the unemployment rate back to the Fed’s longer run estimate. I think the Fed would slide this into the 2019 and 2020 forecasts. This preserves the current gradual part, important because they fear that accelerating the current path raises the risk of recession. In this scenario, the fiscal stimulus extends the tightening cycle, raises the terminal rate, raises the neutral rate, and pushes out the timing of the next recession.
Bottom Line: The Fed is more confident than any time in the past nine months that they will hit their inflation target under the current set of rate projections. Doves in particular had the farthest to move; centrists and hawks already saw the 2017 inflation shortfall as temporary. The risk is that the Fed finds a fourth rate hike in 2018 necessary, but I don’t think they will want to move there until they have more data, maybe by June. But the great fiscal stimulus and larger budget deficit should show up somewhere. I am thinking that is in 2019 and 2020 rate projections and the neutral rate estimates. Given the Fed-speak to date, that seems more likely to me to happen in March than an acceleration of the pace of hikes.