Fed Changing Its Tune

Yesterday I called attention to this line from Federal Reserve Chairman Powell’s testimony:

In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis.

I interpreted this as a shift in the Fed’s focus. The risks are shifting, hence the new concern about an overheated economy. In contrast, previous iterations of this policy guidance referred to “achieving” and then “sustaining” full employment. Central bankers must view the economy as in a danger zone for inflationary pressures.

The next line of the testimony reads:

While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds: In particular, fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory. 

The Fed’s forecast was already only tenuously supportive of three rate hikes. The extra stimulus hence throws the economy into the red zone. If we had any doubt that this policy shift was underway, Julia Coronado of Macropolicy Perspectives catches the topic of Federal Reserve Governor Lael Brainard’s speech next week:

“Navigating Monetary Policy as Headwinds Shift to Tailwinds.”

Yeah, that’s not a coincidence. That’s kind of hitting us over the heads to prepare ourselves for changes in the forecasts and the statement with the next FOMC meeting. First thought is that we will see the “overheating” language appear in the statement, which is to be interpreted as a warning that while they intended to maintain gradual rate hikes, it is more likely that incoming data will trigger an increase rather than decrease the pace of hikes.

Yes, inflation is below the 2 percent target, so on this surface this change in tone seems ludicrous. But the median policy maker forecast in the most recent Summary of Economic Projections is also quite frankly ludicrous. Those forecasts indicate growth well above potential growth in 2018 yet only a small decline in the unemployment rate. And stabilizing unemployment in 2019 with yet another year of growth above potential. And the inflation rate only returns to 2 percent when the temporary factors lift, but by the Fed’s Phillips curve approach the beyond-full employment economy should be much more inflationary when those factors lift, well above the 2 percent target. It all screams for a faster than 3 rate hike pace in 2018, but that was the median policy maker forecast.

I tend to think, and have thought for a long time, that the forecast was essentially reverse engineered as much as possible to keep the rate forecast at three hikes in 2018. Now, with the additional tailwinds sustaining momentum in the economy, they can no longer maintain this façade. Hence the change to the threat of “overheating.”

Bottom Line: I don’t think this is just about three or four hikes. It strikes me as something bigger, a more fundamental change in the policy objective. I understand if you want to resist such an interpretation. We, myself included, all have a lot of ink spilled on gradualism, so there is a natural resistance to changing the story. But as I said Monday, it felt like policy expectations had been set adrift during the transition and I was looking for Powell to re-anchor those expectations. That’s what it looks like he is doing. But he is raising as many questions as he is answering. For instance, I think we need to give some extra weight to the view that 2 percent inflation is a ceiling, not a symmetric target. And now we will be talking about monetary offset. Should get interesting.