Fed Deals with Economic Momentum, Low Inflation, and Its Dual Mandate

This week Fed Chairman Jerome Powell will oversee his first FOMC meeting. The Fed will deliberate on its monetary policy, issue an official Policy Statement, and provide updated forecasts in its quarterly Summary of Projections (SEPs). In addition, Powell will conduct his first press conference.  The Fed is facing growing economic momentum and a host of thorny problems at a time when only three of seven Governors are in place. 

In summary, we expect the Fed to:

• Raise its federal funds rate target to 1.5 percent–1.75 percent, as is widely expected;
• Strengthen its economic forecasts by raising its real GDP forecasts for 2018 to 2.7 percent from 2.5 percent and for 2019 to 2.3 percent from 2.1 percent (it may lower its current unemployment rate forecasts by a tenth); and
• Raise its core inflation forecast for 2018 to 2.0 percent from 1.9 percent.

The median FOMC member’s estimate of the appropriate year-end 2018 and 2019 federal funds rate—the so-called median “dot” —will rise by 25 basis points and imply four rate increases in 2018. The Fed will indicate that it will continue to implement its strategy of a gradual unwind of its balance sheet.

It is vital to point out the current stance of monetary policy and what the Fed faces.  Monetary policy is easy:  while the Fed has begun to raise rates, the federal funds rate remains modestly below inflation. The rate has been negative in real terms since 2008, the longest stretch in Fed history. While the Fed has begun its gradual unwind of its balance sheet, its $4.4 trillion in assets involve roughly $2.1 trillion in excess reserves. 

The economy has been growing significantly faster than the Fed’s estimate of potential growth. Real GDP has expanded 2.5 percent in the last year, well above the Fed’s estimate of 1.8 percent potential growth. The unemployment rate of 4.1 percent has been decidedly below the Fed’s 4.6 percent estimate of its natural rate for over a year, and according to FOMC estimates, is expected to remain below so-called full employment in coming years.

Since the Fed’s December 2017 FOMC meeting, the economy has shown clear signs of building economic momentum with sustained highly-elevated confidence. Congress has passed two important pieces of legislation that pave the way to fiscal stimulus:  the Tax Cuts and Jobs Act, and the Bipartisan Budget Act of 2018. Labor markets have strengthened and although average wage gains have not accelerated materially, there are mounting signs of labor market tightness.

Recently, two traditionally dovish FOMC members, Governor Lael Brainard and New York Federal Reserve Bank President Bill Dudley, have swung their views toward recognizing the strength in the economy.  Former Fed Chair Yellen, a noted dove, has retired from the Board of Governors.  When Chairman Powell testified before Congress on the Fed’s Semiannual Report on the Economy and Monetary Policy, he indicated that the Fed would be reassessing its economic forecasts.

In this context, the Fed faces some key questions.  How much momentum is there in the economy, and will the stronger growth be sustained, or is it temporary?  Will the stronger economic momentum generate “over-heating,” or will it be driven by productivity that helps keep a lid on unit labor costs and inflation? 

In real time, these issues will be difficult to determine, particularly if the Fed properly builds into its forecasts that monetary policy affects the economy and inflation with lags.  If inflation goes above the Fed’s longer-run 2 percent target, will the Fed move aggressively to constrain it? Or will the Fed acknowledge that, following a handful of years of inflation below 2 percent, allowing inflation above 2 percent is acceptable for a while?  And how much inflation above 2 percent, and for how long would it be tolerable? 

Importantly, how does the Fed communicate in a way that does not jar financial markets and the economy?   We expect Powell’s communications to focus less than Yellen’s on detailed labor market conditions with which she was more comfortable, and more toward overall economic performance and the Fed’s role in supporting sustained expansion. 

Mickey Levy is the chief economist for the Americas and Asia of Berenberg Capital Markets, LLC, and member, Shadow Open Market Committee. 

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