Commentary://Tim Duy//July 19, 2018
//July 19, 2018
Change is in the air at the Federal Reserve. Chairman Jerome Powell’s semiannual monetary policy testimony in the Senate gave a big hint that we can no longer count on the explicit policy of gradual interest-rate hikes to continue too much longer. That doesn’t mean gradual rate increases will end, only that the Fed will rely less on forward guidance. A slower or faster pace of hikes, an extended pause, or even a rate cut are all possibilities at this point.
In his testimony Tuesday, Powell added the qualifier “for now” as he reiterated the Fed’s commitment to the current policy of gradual rate increases. This addition signals that the Fed is preparing for a shift in their policy guidance. Why prepare for a shift? Policy rates will soon approach the central tendency range of what policy makers estimate to be neutral, currently 2.8 percent to 3 percent. But that range is just an estimate. The true neutral rate is unobservable.
Hence, as rates approach that range, policy makers need to more carefully assess the current and expected state of the economy before blindly pushing rates higher. They could afford to be on autopilot when rates were far from neutral; they will soon no longer have that luxury.
The next two rates hikes are looking like a near certainty at this point. The economy exhibits too little inflation to consider accelerating the pace of rate hikes with an August hike and retains too much momentum for the Fed to consider pausing at the September meeting.
Moreover, I doubt this calculus will change by fourth quarter, meaning a hike in December but not October.
By 2019, however, the guidance will shift away from an implicit expectation of a 25-basis-point boost each quarter. Officials will increasingly emphasize the role of incoming data when setting policy. In his testimony, Powell provided a clue on what to look for when sifting through the data.
He noted that recent job growth is “a good deal higher than the average number of people who enter the work force each month on net.” I don’t think the Fed will believe they have reached a neutral rate until this is no longer the case. Consequently, to take an extended pause, central bankers will be looking for job growth closer to 100,000 per month, a figure they expect will stabilize the unemployment rate once the cyclical force of a solid economy supporting labor force participation wanes and becomes dominated by the secular force of older workers leaving the workforce as they retire.
Simply put, the Fed is not likely to believe they have reached a neutral policy stance as long as the labor market is sufficiently strong to place ongoing downward pressure on unemployment. As such, the Fed would continue pushing policy rates higher while searching for neutral. Do not underestimate the Fed’s determination on this point.
That said, if the pace of economic activity eases such that they can reasonably forecast slower job growth while inflation remains contained, they will likely shift toward an even more gradual and uneven policy path. For example, if conditions drove job growth toward a range of 125,000 to 150,000 per month, policy makers would be comfortable skipping the March meeting while being very careful to say they did not expect they had concluded the policy normalization process. After all, unemployment would still be below their estimates of the natural rate of unemployment, and they would expect that some additional slowing of activity was still necessary to get to that point.
Alternatively, if they get any signals consistent with an overheated economy, which could come in the form of accelerating wage growth or a whiff of inflation, the Fed will likely step up the pace of hikes, shifting to two meetings in a row for example. If trade wars weigh more heavily on the U.S. economy than expected, the Fed could even cut rates.
The Fed is likely to continue to hike rates at a pace of 25 basis points per quarter until the tenor of the data shifts conclusively in one direction or another. Powell, however, is letting us know markets shouldn’t take this for granted. In other words, the Fed intends to create more smoke around policy meetings. Market participants will have to work harder to see through that smoke.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy’s Fed Watch.i