Thinking about the path of policy next year, this quote from Chicago Federal Reserve President Charles Evans (via the New York Times) seems like an important issue:
I think the economy is doing very well. I think it continues to show strength. The second half is looking like very good growth: 2.5 to 3 percent growth. And this is to be measured against our assessment that sustainable growth is more like 1.75 percent. So 2.5 to 3 percent is very strong growth, which should continue to lead to improved labor market activity.
Unless something structural improves to increase trend growth, we're going to be decelerating to something under 2 percent - and that will still be a pretty good economic picture.
On the surface, this is a fairly straightforward analysis. The supply side of the economy currently grows at roughly 1.75 percent. The demand side is growing at 2.5-3 percent. So, it must be true that activity slows to something under 2 percent.
Indeed, this basic story forms the backbone of monetary policy decisions. Essentially, the economy currently operates at or near full employment, the current pace of activity will take the economy well beyond full employment, and thus the economy must slow to prevent overheating.
The question I have is what does Evans believe triggers this slowdown? That question gets at the heart of the interest rate forecasts for 2018. Does this slowdown occur endogenously as the result of the economy running up against supply-side constraints? Or is it the lagged response of past monetary tightening? Or is further monetary tightening required to restrain growth?
If your answer is either of the first two choices, you feel little need to raise interest rates in December, especially with inflation running soft. Evans appears to be leaning toward the second option:
I think our policy moves to date have been thoughtful and reasonable. We've increased our funds rate objective by 100 basis points. Maybe it's time to stop and see whether inflation expectations are going to move in line with our 2 percent objective. And if the judgment was that we're still likely to be underrunning our 2 percent objective, maybe we would stop briefly and assess for more information, maybe wait until mid-2018.
In short, the Fed has already done a lot, growth likely to slow, and inflation is a mystery, so why hike now?
But if your answer is the third option, then you believe that the necessary (at least in the Fed's view) tempering of economic activity will only occur after additional monetary tightening.
In either case, you eventually get a slowing of economic activity. But the path of short-term rates looks very different. I think the majority of Fed policymakers fall into the third category and thus are more likely than not to see the solid growth of the past three quarters as a signal that the economy will overheat without the projected additional rate hikes in December (25 basis points) and next year (75 basis points). Which is why I expect that as long as the economy looks likely to drive unemployment rate lower, the Fed will remain biased toward hiking rates.