Federal Reserve Governor Lael Brainard gave her policy guidance as Fed officials continue to set the stage for this month’s FOMC meeting. There is something for everyone in this speech, but it concludes with a strong warning that evolving economic conditions might force the Fed into a faster pace of rate hikes.
The speech is somewhat fascinating in the degree of care taken in delivering her message. This I suspect reflects fears that market participants will react poorly to any hint that the Fed may accelerate the pace of rate hikes. Brainard begins:
Many of the forces that acted as headwinds to U.S. growth and weighed on policy in previous years are generating tailwinds currently. Today many economies around the world are experiencing synchronized growth, in contrast to the 2015-16 period when important foreign economies experienced adverse shocks and anemic demand.
She is comparing the current period to 2015-16. Keep that in mind – it becomes important for the conclusion. In comparison to then, the global economy is stronger, the dollar is falling, oil prices are rising, US business investment is on the rebound, and financial conditions are supportive of growth. In addition:
The most notable tailwind is the shift in America’s fiscal policy stance from restraint to substantial stimulus in an economy close to full employment. In the earlier period, the economy had just weathered a challenging adjustment to a sharp withdrawal of fiscal support. Today, from a position near full employment, the economy is poised to absorb $1-1/2 trillion in personal and corporate tax cuts and a $300 billion increase in federal spending. Estimates suggest December’s tax legislation could boost the growth rate of real gross domestic product (GDP) as much as 1/2 percentage point this year and next. On top of that, the recently agreed-to budget deal is likely to raise federal spending by around 0.4 percent of GDP in each of the next two years.
There are two important points here. First, she describes the economy at near full employment. Second, she estimates the impact of new fiscal spending at 0.4 percentage points of GDP. Think about the combination for a second. The Fed forecasts from December expect 2.5 percent growth in 2018, relative to a 1.8 percent potential growth rate. If the fiscal spending since that forecast feeds into the GDP forecast one for one, that amounts to 2.9 percent growth in 2018. Relative to 1.8 percent potential. For an economy near full employment.
It is easy to see how, with that forecast, unemployment blows straight through Fed’s current forecast of 3.9 percent for the end of the year (actually, it is easy to see how that happens even without the additional fiscal spending). Keep a close eye on the forecasts in the next Summary of Economic projections. Watch for inconsistencies. How much is the growth forecast revised upward? How much is unemployment revised downward? That’s where you will find the risks to the rate forecast.
After describing the tailwinds, the dovish side of Brainard makes an appearance:
The persistence of subdued inflation, despite an unemployment rate that has moved below most estimates of its natural rate, suggests some risk that underlying inflation may have softened…it is important for monetary policy to ensure that underlying inflation is re-anchored firmly at 2 percent.
Brainard still has concerns that inflation expectations have dipped, and wants to see those expectations pulled back up to 2 percent. That suggests no rush to hike rates. And the other half of the dual mandate:
At the same time, it is important for monetary policy to sustain full employment.
This is interesting. Remember that in Federal Reserve Chairman Jerome Powell’s testimony last week, the story on the labor market was “avoiding overheating.” Brainard pulls that back to “sustaining full employment.” Is Brainard trying to un-ring that bell? I am hoping someone asks Powell about the overheating line in the upcoming press conference.
How near is “near” full employment? Who knows? Brainard:
It is difficult to know with precision how much slack remains in the labor market. If the unemployment rate were to continue to fall in the coming year at the same pace as in the past couple of years, it would reach levels not seen since the late 1960s.
I have heard that comparison to the late 1960’s somewhere before. Still, Brainard is at least modestly optimistic that there remains some slack in the labor market. With inflation expectations still a little soft and some lingering slack in the labor market, Brainard blesses the Fed’s current anticipated rate path:
Although last year we faced a disconnect between the continued strengthening in the labor market and the step-down in inflation, mounting tailwinds at a time of full employment and above-trend growth tip the balance of considerations in my view. With greater confidence in achieving the inflation target, continued gradual increases in the federal funds rate are likely to be appropriate.
That sounds like a move from two dots to three for 2018. She also, appropriately in my view, emphasizes that inflation overshoots were perfectly acceptable:
Of course, it is conceivable we could see a mild, temporary overshoot of the inflation target over the medium term. If such a mild, temporary overshoot were to occur, it would likely be consistent with the symmetry of the FOMC’s target and could help nudge underlying inflation back to our target.
Then come the warnings:
We also seek to sustain full employment, and we will want to be attentive to imbalances that could jeopardize this goal. If the unemployment rate continues to decline on the current trajectory, it could fall to levels that have been rarely seen over the past five decades. Historically, such episodes have tended to see elevated risks of imbalances, whether in the form of high inflation in earlier decades or of financial imbalances in recent decades.
Follow that for a second. Brainard is saying the imbalance might not be inflation, but financial. For those of you worried that the Fed isn’t paying enough attention to asset prices, that line is for you. She is clearly ready to fight the last war if need be.
Brainard references the flat Phillips curve and low wage gains, but comes back to this point:
However, we do not have extensive experience with an economy at very low unemployment rates and cannot be sure how it might evolve. In particular, we will want to remain attentive to the risk of financial imbalances. While asset valuations appear to be elevated, overall risks to the financial system remain moderate because household borrowing is moderate, risks associated with liquidity and maturity transformation have declined, and, importantly, the banking system appears to be well capitalized. History suggests, however, that a booming economy can lead to a relaxation in lending standards, and the attendant excessive borrowing can complicate the task of monetary policy. We will need to be vigilant.
Back to the financial imbalances. Another signal that while she might not be worried about inflation, she is worried about the sowing the seeds of financial crisis.
The punchline is the conclusion:
In many respects, the macro environment today is the mirror image of the environment we confronted a couple of years ago. In the earlier period, strong headwinds sapped the momentum of the recovery and weighed down the path of policy. Today, with headwinds shifting to tailwinds, the reverse could hold true.
Back to the 2015-16 comparison. Let’s think about that for a second. In 2015, Brainard sounded the alarm on the Fed’s expected rate path. She was ultimately proven correct; the Fed’s expected four hikes in 2016 became just one. That’s a sharp deceleration relative to the expected path. Today’s economic environment is a “mirror image” of then. That opens the door to a sharp acceleration. That’s the warning – the balance of risks has shifted. If she is as prescient as she was in 2015, you know what’s coming.
Bottom Line: Lots to chew on here. But ultimately, it sounds as if Brainard is throwing off her more dovish concerns of last year and is ready to come into the consensus. But more ominous is her warning: The economy is near full employment with substantial tailwinds that could quickly push the Fed into uncharted territory. Unspoken directly of course is that the situation might reverse if the chaos in the White House derails the US economy.