Some Fed officials have signaled in the weeks since the September FOMC meeting that the economy may be so strong that they might have to raise the federal funds rate higher than they had mentioned doing. That would be unfortunate, given how well they've prepared the financial markets for a federal funds rate raised to 3.0% by the end of 2019.
Now they're talking more about 3.40% in 2020. Is that really necessary? A "gradual normalization" of the federal funds rate to what they claim is a "neutral" rate (3.0% in 2019) has been clearly telegraphed and is widely anticipated. Why suddenly speculate about turning restrictive in 2020?
It was widely noted that the Sept. 26 FOMC statement deleted the following language that had appeared in previous statements: "The stance of monetary policy remains accommodative." This sentence had been in every FOMC statement since December 2015, when the Fed started its latest rate-hiking program.
Some interpreted the omission to mean that the Fed is setting up for more aggressive rate increases. On the contrary, at his Sept. 26 press conference, Fed Chairman Jerome Powell reassuringly said that the language simply had outlived its "useful life." So the Fed will continue its gradual rate increases toward a neutral stance.
Nevertheless, the markets are starting to fear that the Fed may be heading toward restricting economic growth. Consider:
1. Dot plots: The Fed's quarterly dot plot has become the semi-official playbook for the FOMC. It showed that last March 21, the committee's median forecastfor the federal funds rate was raised to 3.4% in 2020 from 3.1%, further above the "longer-run" forecast of 2.9%, which had also been raised from 2.8%, as shown in Table 1.
2. Latest minutes: Despite the March 21 increase in the 2020 federal funds rate forecast, the S&P 500 SPX, -0.55% rose 13.6% from this year's low on February 8 to a record high on Sept. 20. It's down since then, partly because Fed officials have upped the ante by signaling that their policy might have to turn from accommodative to neutral to outright restrictive given the strength of the economy. That gave the 3.4% forecast for 2020 more credibility.
So, for example, the word "restrictive" appeared in September's FOMC minutes for the first time during the current economic expansion, as follows:
"Participants offered their views about how much additional policy firming would likely be required for the Committee to sustainably achieve its objectives of maximum employment and 2 percent inflation. A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level in order to reduce the risk of a sustained overshooting of the Committee's 2 percent inflation objective or the risk posed by significant financial imbalances. A couple of participants indicated that they would not favor adopting a restrictive policy stance in the absence of clear signs of an overheating economy and rising inflation."
3. Brainard and Powell are both open to overshooting neutral: During the Q&A of his press conference, Powell was asked whether the Fed might end the tightening cycle in a "restrictive posture," as Fed Governor Lael Brainard had suggested in a Sept. 12 speech. Powell responded: "It's very possible." He added: "Maybe we will keep our neutral rate here [i.e., at 3.0%], and then go one or two rate increases beyond it." If the U.S. economy continues to perform as the Fed expects, we expect that the Fed will stop tightening at around 3.25%-3.50% during 2020. That would be two 25-basis-point hikes above the Summary of Economic Projections’ (SEP) longer-run projection of 3.0% for the federal funds rate.
In her speech, Brainard explained: "In the latest FOMC SEP median path, by the end of next year, the federal funds rate is projected to rise to a level that exceeds the longer-run federal funds rate during a time when real GDP growth is projected to exceed its longer-run pace and unemployment continues to fall. The shift from headwinds to tailwinds may be expected to push the shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell below the longer-run equilibrium rate following the financial crisis."
Now let's review the FOMC's other economic projections. For real GDP growth, Table 2 shows that the median forecast of the FOMC for this year has increased to 3.1% in September's SEP from 2.5% at the end of last year. Growth is expected to decelerate to 2.5% in 2019, to 2.0% in 2020, and to just 1.8% in 2021, which is deemed to be the long-run potential of the economy.
That's a fairly dour outlook. FOMC participants aren't buying the supply-side story that tax cuts may boost productivity. So they feel compelled to raise rates to slow the economy to its long-run potential, with the aim of keeping inflationary pressures from rising as a consequence of the short-run stimulative impact of Trump's tax cuts. No wonder Trump isn't happy with Powell. He probably regrets not having extended Janet Yellen's employment contract.
The SEP also shows that the median forecast for the unemployment rate for this year fell from 3.9% at the end of 2017 to 3.7% last month. Next year, it is expected to fall to 3.5% and stay there through 2020. But then it is projected to edge back up to 3.7%. The long-run jobless rate is deemed to be 4.5% (Table 3). No wonder Fed officials are talking about turning restrictive: They believe the unemployment rate is already well below its non-accelerating inflation rate of unemployment (NAIRU).
What if they are wrong and inflation remains subdued, as I expect? If that happens, then Fed officials may have to acknowledge that NAIRU might be lower than they currently believe. The Congressional Budget Office (CBO) estimates that NAIRU is currently between 4.5% and 5.0% (Fig. 1). The actual unemployment rate fell well below that range, to 3.7%, during September, yet inflation hasn't accelerated. Could it be that NAIRU, which is unobservable, might be lower than the CBO's model estimates? I think so. By the way, the CBO's model also shows the ratio of actual real GDP to potential at 1.0 during the second quarter, the highest since the fourth-quarter of 2007 (Fig. 2).
Finally, the SEP's median inflation forecast, based on the core PCED, is remarkable. For this year, it was raised to 2.0% from 1.9% at the end of last year. Over the next two years, it is expected to be 2.1%. FOMC participants believe that, thanks to their monetary policymaking, inflation will remain in line with their 2.0% target for the foreseeable future (Table 4).
Could it be that Fed officials have too much free time on their hands, and that's why they concoct all sorts of cockamamie theories? For example, consider the Oct.18 speechby Fed Governor Randal K. Quarles entitled "Don't Chase the Needles: An Optimistic Assessment of the Economic Outlook and Monetary Policy."
He starts with two Hamletesque questions: "How long can this strong growth be sustained? The answer depends largely on what form growth takes. Growth that is supported by increases in the productive capacity of the economy should be durable. However, if growth primarily reflects strong demand that stretches production beyond its sustainable capacity, the economy will run into constraints that will result in slower growth, higher prices, or a potentially destabilizing buildup of financial imbalances. So, which is it?"
Quarles isn't sure, which is why he supports the Fed's gradual normalization of monetary policy. Quarles hopes that there is still enough slack in the labor market and that technological innovations will boost productivity growth enough to increase potential output, without reviving inflation. He fears that if that doesn't happen, then strong demand could lift inflation.
Quarles acknowledges that "potential output is unobserved and can only be inferred from the behavior of other measured economic indicators." He states that inflation is "the primary indicator of the economy's position relative to [its] potential."
Now put on your thinking cap: Says Quarles: "Perhaps inflation is just sending a signal of people's trust in the Fed's ability to meet its inflation objective. If so, no complaints here. That is a good thing. However, a problem does arise if the Fed remains reliant on inflation as our only gauge of the economy's position relative to its potential. There are risks in pushing the economy into a place it does not want to go if we limit ourselves to navigating by what might be a faulty indicator. Anchored inflation expectations might mask the inflation signal coming from an overheated economy for a period, but I have no doubt that prices would eventually move up in response to resource constraints. The ultimate price, from the perspective of the dual mandate, would be an unanchoring of inflation expectations."
I hope no further explanation is required, because I'm not sure there is much more I could add to explain this head-spinning concept.
Ed Yardeni is president of Yardeni Research Inc., a provider of global investment strategy and asset allocation analyses and recommendations. He is the author of Predicting the Markets: A Professional Autobiography (2018). Follow him on Twitterand LinkedIn.
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