By Thanos Bardas, PhD
The Fed's formulaic rate increases continue, but with an eye toward various disruptive side issues.
In the run-up to this week's meeting, the Federal Reserve gained more clarity as to its upward interest rate path with continued progress in employment and economic growth. Core PCE strengthened from 1.5% toward 1.8% currently, the U.S. unemployment rate dipped from 4.1% to 3.8% - a level last seen in 2000 - and 2Q GDP is running at an estimated 4% pace versus 2% for 1Q, for a six-month average of around 3%. Despite the substantial acceleration in growth versus potential GDP, real average hourly earnings gains remain close to zero.
Given the generally positive picture, it came as little surprise Wednesday when the FOMC increased the Fed Funds rate by another 25 basis points to 1.75-2.0%. Chairman Jerome Powell noted solid growth and strong employment statistics, as well as healthy household spending and business investment, as factors behind the decision. Interestingly, the Fed dots inched up slightly, implying another two rate increases this year and three in 2019, a bit higher than market expectations.
Still, that doesn't mean the Fed is looking to become aggressive by any means. This has been a particularly long recovery in which the PCE inflation measure that the Fed favors has only averaged 1.5%, compared to 1.9% in the previous, much shorter (2001-2007) cycle. In view of that extended subpar result, the U.S. central bank seems willing to tolerate modestly higher inflation from here to achieve a "symmetric" target of 2%. A lack of aggressive inflation moves should inhibit aggressive Fed action over the next few quarters.
Global Volatility and the 'Cliff'
Although probably not enough to derail its current plans, the Fed also has its eye on volatility that has been engulfing much of the world's markets: equities in the first quarter and credit/emerging markets debt in the second, accompanied by a slew of one-off tremors in multiple countries: the surge in Italian yields, capital flight from Turkey, Brazilian labor strikes, Argentina's IMF rescue, fallout in Mexico from trade fears. EM hard currency sovereign debt has seen yields increase by more than 100 basis points this year.
A key question, of course, is how long the rate increases will last.
Looking back at March 2016, when weakness in China and the commodities complex fed deflationary fears, the Fed's intermediate and long-term median targets for the Fed Funds rate were 3% and 3.3%, respectively - suggesting potential for economic acceleration. Today, despite currently strong growth figures, those statistics have flipped - to 3.4% and 2.9%, respectively - suggesting an eventual slowdown.
The reason is a sharp tightening of financial conditions. Although last year saw rate increases, the weak dollar, a surge in business activity tied to tax cuts/deregulation and the strong stock market actually loosened credit. But this year the cumulative impacts of Fed policy and a strong dollar have contributed to choppy market conditions, which have sent credit market yields up more than Treasury yields. It appears that current economic strength is being ginned by fiscal stimulus -the effects of which will likely run off by late 2019-2020 in what is becoming known as the "fiscal cliff."
Then there's what I would call the "convergence/divergence" paradox of current monetary policy. Central banks largely converged around zero interest rate policy a few years ago until the U.S. diverged into quantitative tightening and rate hikes. But just as it appears that Europe is close to moving toward QT, the U.S. is seeing the end of tightening on the horizon, perhaps by 2020. Something has got to give in this situation, and I have to think that it will ultimately be the ECB that moves toward the Fed position.
Overall, the issue of three versus four rate hikes in 2018 is less relevant, judging by the market reaction post Wednesday's FOMC meeting. But with the curve of forward Libor close to flat (i.e., the difference between December 2019 and December 2021 is about four basis points), it seems likely that the Fed will take a breather sometime next year to assess conditions and what happens next.
One thing that has changed is the Fed's elimination of forward guidance on the stance of monetary policy. It was a feature that former chairmen had in place to explain the "low-for-longer" policy of the Fed. But now that short-term real rates are closer to equilibrium, the previous regime is over. So, I think Chairman Powell and his colleagues will be required to have more flexibility in reacting to changing market conditions, and also to communicate more often with the markets - something that will be accomplished via additional FOMC press conferences starting in January.
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