Entering the Danger Zone
As we wait for Federal Reserve Chair Jerome Powell to take the podium in Jackson Hole and impart some wisdom on the economy and hopefully provide policy guidance as well, it is worth considering that we may be soon be entering a dangerous period for monetary policy – the time when the lagged effects of previous rate hikes have yet to reveal themselves in the form of slowing growth while inflation numbers continue to firm.
It is in such an environment in which the Fed has to be willing to take a risk that their estimates of neutral policy are more right than wrong and pull back from rate hikes if they want to keep the expansion alive. But Powell & Co. take such a leap of faith?
The US economy continues to ride along on the momentum of the first quarter. Economists surveyed by Bloomberg expect 3.0% growth in the first quarter, down from a smoking hot 4.1% the first quarter but still well above the 1.8% growth rate the Fed believes sustainable over the longer run. The Atlanta Fed is currently looking for another 4+% growth quarter. Job growth has been running at a monthly rate of 224,000 the past three months while the forward-looking indicator of initial jobless claims has been pinned down at record lows, promising more job gains to come. Manufacturing activity remains solid as well.
Moreover, the economy holds strong despite the uncertainty of trade wars and an emerging market pullback that includes the threat of financial crisis in Turkey. Overall, most important is that the Fed’s monetary tightening to date has apparently done little to slow the pace of activity down toward something the Fed thinks will ultimate be sustainable and noninflationary.
While the economy chugs along, price pressures are firming as evidenced by the rise of core-CPI inflation in July to 2.4%. To be sure, the Fed will tolerate some overshooting of their inflation target – it’s a symmetric target, not a ceiling. They will not overreact and accelerate the pace of tightening unless the overshooting looks to be significant and persistent. The rebound of inflation coupled with solid growth prospects looks likely to keep the Fed hiking rates at least twice more this year and into next as well.
Presumably, the Fed will be looking for an opportunity to pause in early 2019 so they can see the impact of their work. But will the data cooperate? Central bankers need some of the momentum of recent quarters to fade as tighter monetary policy and higher resource costs straight to weigh on aggregate activity. For example, I am hearing anecdotal stories of slacking demand for commercial construction due to sticker shock. Additionally, they will be looking toward 2019 and the fading impact of fiscal stimulus on the economy.
Such an actual and expected slacking of demand, combined with contained inflation and an increase of risks from abroad, could give the Fed room to pause. I view this as a best-case scenario in which the Fed shifts to an extended policy pause before a slowdown becomes so deeply ingrained that it turns to recession.
Danger lurks, however, in this stage of the business cycle. Due to long and variable lags in monetary policy, activity might not slow sufficiently quickly to deter the Fed from hiking rates. Moreover, they may still be witnessing a lagged impact of higher inflation from prior economic strength. This combination could push the Fed to hold rates higher for longer than is appropriate for the economy. Indeed, this is an error I believe the Bernanke Fed made at the height of its tightening cycle.
My sense is that the Fed will resist pausing until the data suggests enough slowing to put the economy on a sustainable path. If true, this is where the risk of recession rises as policy transitions from “less accommodative” to “neutral” to “restrictive.” That said, should Powell’s comments at Jackson Hole be relevant for the near-term policy path, I am watching for signals that he is looking to raise policy rates another 50 or 75 basis points into the range of estimates of the neutral rate and then be willing to pause even if the data flow remains strong. This will take of a leap of faith on the part of the Fed that their estimates of neutral are more correct than not and that continuing strong data simply reflects a policy lag.
Bottom Line: In recent years, the Fed has tended to choose recession over the risk of higher inflation, with the result being recessions in 2001 and again in 2007-09 while inflation remains locked down to the point it drifted persistent below the Fed’s target in recent years. Powell’s relative dovishness on inflation – he is more concerned that inflation expectations may have drifted downward than that they are poised to shift higher – may turn out to be the key insight that allows the Fed to navigate the economy through the coming policy danger zone. But beware that the Fed often just can’t stop itself from hiking until the data turn (too much backcasting and too little forecasting), which will most likely be too late to stave off recession.