Beyond “Maximum Employment,” Headed Beyond “Price Stability”

No rate decision, no update of macro or funds rate projections, no press conference. Just the statement!  Given that there will be no press conference or updated projections and that markets are well aligned with the Committee’s expectation for a hike in June, there is little desire to make substantial changes to the statement. However, given that 12-month core PCE inflation has now risen to the edge of 2%, some change in the language about inflation is warranted.  

• In the first paragraph, we expect the statement to say that both overall inflation and inflation for items  other than food and energy are “close to 2 percent,” rather than “have continued to run below 2 percent.” • In the second paragraph, we expect the statement to say that inflation on a 12-month basis is expected  to “stabilize around the Committee’s 2 percent objective over the medium term,” rather than “move up  in coming months.” 

The FOMC was navigating toward a soft-ish landing, but the fiscal stimulus put them behind the curve, which is exactly what they were trying to avoid. 

• In terms of the fund’s rate, that means rate hikes must now be faster and go further. • Our rate path remains a little faster than the FOMC’s median projection, reflecting our expectation that inflation will overshoot the 2% objective earlier and to a greater degree.  

• The faster pace and hiking rates above the neutral level increases the risk of recession. 

This means the FOMC faces a difficult balancing act. 

• The focus is turning toward limiting the degree of overshoot of the 2% objective, rather than merely  reaching 2%. 

• The balancing act is to go fast enough to limit the overshoot of 2% but not so fast as to endanger the  expansion. 

Still, the economy at the end of 2020 is projected to look very good. While the FOMC would be missing on both parts of its mandate, the combination of 2¼% inflation and 3½% unemployment is very attractive. We call it missing on both mandates and feeling good.  

• By 2020, the economy is projected to have slowed to trend. In the FOMC’s March macro projections,  inflation stabilizes at about 2%. In our forecast, inflation is 2.3% in 2020.  

• And the tradeoff between inflation and unemployment appears very favorable, just a ¼-percentage-point  overshoot of inflation for a one-percentage-point decline in the unemployment rate below the NAIRU. • The question is whether the outcome in 2020 is sustainable. History suggests that a decline in the unemployment rate so far below the NAIRU does not end well.  

One question related to sustainability is the potential for an inversion of the yield curve, historically a harbinger of recession. At this meeting, we expect there will be a discussion, which will be revealed in the minutes,  but not the statement. 

• A yield curve inversion is seen as a signal of recession because it reflects a very aggressive tightening by the Fed that often precedes recessions. This is the price of getting behind the curve. • One reason not to be overly concerned is that it takes less of a rise in the fund’s rate to invert the curve given that the term premium is near zero. So the message of an inversion is less powerful. 

The Outlook Context 

The Committee will look through the weak first quarter and the well-below-consensus gain in payroll employment in March and see the outlook for growth and the labor market as relatively unchanged. The focus will be on the broad contours of the outlook as reflected in the March projections: above-trend growth when the unemployment rate is already below the NAIRU leading to a further decline in the unemployment rate, to a level that the Committee would have preferred not to see. The discussion of inflation will follow the assessment at the March meeting that inflation was firming, which made policymakers more confident that inflation would reach 2%. With 12-month core PCE inflation likely to be within a tenth of 2% in March,  we expect they will judge that the economy is effectively at price stability.  

A Modest Q1 Ahead of the Boost from Fiscal Stimulus 

Real GDP growth was 2.3% in Q1, below what we see as its underlying trend this year. Furthermore, final private demand grew even more slowly. The Committee will discuss how much of a signal should be taken from this. The answer is almost certainly not much. Growth in 2018 is expected to be boosted by fiscal stimulus, but that didn’t help Q1. A weak first quarter has also been a pattern in recent years. In addition,  the underlying fundamentals look favorable: strong employment growth supporting income growth, high consumer confidence and business sentiment, a synchronous worldwide expansion, still-very-accommodative financial conditions, and, of course, fiscal stimulus. Nevertheless, monthly spending indicators as we head into mid-year will become more important, indicating whether the slowdown in Q1 represented a more meaningful slowing, at least one spilling over into Q2.  

Fiscal Stimulus and Monetary Policy Response 

The macro story this year, with the unemployment rate already below the NAIRU and inflation closing in on  2%, is the boost to growth from fiscal policy and the response of monetary policy: a faster pace of rate hikes and an eventual rise above the neutral level. We expect fiscal stimulus to boost growth to about 3%  in the second half of 2018. Consequently, we expect four rate hikes in total this year and another four in 

2019. It is too late for monetary policy to have a restraining effect on growth in 2018, but the pace and cumulative degree of tightening is expected to offset much of the incremental effect of the fiscal stimulus in  2019 and 2020. Still, this leaves the level of GDP higher at the end of 2020–by more than ¾ percentage point, we expect–and the unemployment rate correspondingly lower. 

Beyond “Maximum Employment” 

The Committee estimates the NAIRU is 4½%. The prevailing unemployment rate is 4.1%, and it has been stable for six months in a row now. But it is the forecast that is now a concern: a resumed decline in the unemployment rate to 3½%, far below the NAIRU and low enough that it will likely put more upward pressure on inflation. The slowdown in payroll employment growth in March is easy to look through, given the robust underlying trend, a pace consistent with further declines in the unemployment rate. The ECI data for the  18:Q1 also showed a material uptick.  

Headed Beyond Price Stability 

At this meeting not only will the Committee be confident that inflation will soon reach 2%, but it will also be mindful that inflation is already at (or nearly at) its objective, given that 12-month core PCE inflation is likely to be reported as 1.9% in March. And, importantly, this is the first reading not distorted by the price level shock in March 2017 that caused an outright decline in core PCE prices. There will be a greater recognition that inflation is headed above the 2% objective. And the probability has risen that the overshoot will emerge this year and build over 2019 and 2020. So the Committee is soon about to miss on the price stability mandate as well.

The FOMC Call 

There will no change in the fund’s rate at this meeting, of course. The policy question is no longer how to achieve a soft-ish landing but rather how to preserve the best possible outcome over the next couple of years. The answer is by tightening sufficiently to lean against a decline in the unemployment rate below  3½% and to limit the overshoot of the 2% objective without going too fast and too far and, in the process,  bring on a recession. In the end, however, a recession may be the only way out. At this meeting, with no need to signal anything about June, the FOMC will likely focus on crafting a statement that acknowledges recent developments in the data, particularly with respect to inflation, without boxing them in at future meetings as they continue to consider these policy questions. 

Coming Soon: Not Meeting Either Mandate, but Not a Bad Outcome Through 2020! 

The FOMC saw the unemployment rate fall below the NAIRU, initially only modestly before it stabilized. Inflation was headed toward 2%. Given the flatness of the Phillips curve, which offered a  favorable trade-off, we were headed toward what we would call a soft-ish landing. The only blemish was the possibility that inflation would then accelerate as long as the unemployment rate was below the NAIRU.  But that would be a result of inflation expectations following inflation higher. We expect many, even most,  on the Committee, if pressed, would have acknowledged that inflation expectations had eroded to some degree. In this case, a modest overshoot of 2% might be desired, to raise inflation expectations back to  2%. Let’s face it: 2¼% inflation and 3½% unemployment are quite favorable. But the danger is lurking. If a  softish landing requires the unemployment rate to rise toward the NAIRU, this cannot end well. But it can be sustained in the meantime! 

The Policy Challenge: Sustaining the Expansion, Limiting the Overshoot of 2% 

There will be a debate about how to limit the overshoot of inflation while sustaining the expansion. Given what the economy has been through, there is a priority in sustaining the recovery: How to get this balance right and sustain a good outcome for as long as possible is the challenge.  

Message in the Statement 

The key decision the FOMC will face is how to change the statement to reflect that core inflation has firmed further–to the point that inflation is close to the 2% objective–and that the Committee expects inflation to stabilize around 2%. That’s consistent with the median March projections, which have inflation at 2.1% in  2019 and 2020. In various places, the language of the statement for some time has been structured for circumstances in which inflation was below its objective but projected to return to its objective. We expect the FOMC to take the path of least resistance at this meeting, changing the statement as little as possible while acknowledging that inflation has risen to close to its objective. The fact that there will be no press conference, projections, or funds rate hike at this meeting support such a route. In the first paragraph, we  think they’ll simply state that inflation on a 12-month basis is now “close to 2 percent.” We think they’ll remove references in the forward-looking second paragraph (“expected to move up in coming months”) and the third paragraph (“a sustained return to 2 percent inflation”) to inflation returning to its objective. In the  sentence on the balance of risks at the end of the second paragraph, we think they’ll remove the part reading,  “the Committee is monitoring inflation developments closely.” 

That inflation is near the objective raises some tension in the line stressing that policy will remain  accommodative for some time: “The stance of monetary policy remains accommodative, thereby supporting  strong labor market conditions and a sustained return to 2 percent inflation.” With the labor market strong and inflation no longer under its objective, this rationale for maintaining monetary accommodation is a bit strained. But we think they can address this adequately for now by changing “a sustained return to 2 percent  inflation” to “inflation near its 2 percent objective.” Also, we believe that they will keep the description of developments in market-based inflation compensation unchanged (“remained low”), as the current level of  5y5y BEI is similar to its levels in 2015, when this language first appeared.

A related issue is whether they change the forward guidance on the fund’s rate, in the fourth paragraph. This  guidance includes the line, “The Committee expects that economic conditions will evolve in a manner that  will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for  some time, below levels that are expected to prevail in the longer run.” We take that as a reference to remaining accommodative, that is, at a funds rate below neutral. We expect the emphasis will soon shift to policy heading back to neutral. But we don’t expect a change at this meeting. 

One question is whether and how much the Committee adjusts the language on spending in the first paragraph. We expect the Committee will still refer to growth as “moderate”–2.3% in Q1 certainly still qualifies. But the sentence on household spending and business fixed investment saying both “moderated from their strong fourth-quarter readings” could use some adjusting. With PCE at 1.1% and residential investment at 0.0% in Q1, that doesn’t seem like an appropriate characterization of household spending. That’s more than moderation, even if it’s not a cause for concern. As for business fixed investment, going from 6.8% to 6.1% in Q1 doesn’t seem like much of a moderation (though equipment going from 11.6% to 4.7% qualifies). More like continued solid growth. We think they’ll adjust the language in this direction. 

In the second paragraph, as a base case, we have them keeping the sentence that they added in the March  statement, “The economic outlook has strengthened in recent months.” It’s a bit strained since the outlook hasn’t strengthened since the March meeting. They could remove this sentence, but that would certainly be seen as dovish. It’s quite possible that they’ll adjust the language, however. Whatever the case, we wouldn’t read too much into it. 

Our Guess of The Statement 

Information received since the Federal Open Market Committee met in March January indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate. Job gains have been strong in recent months, on average, and the unemployment rate has stayed low. Recent data suggest that the growth rates of household spending slowed from its strong fourth-quarter reading, while growth in and business fixed investment remained solid. continued to advance at a solid pace. have moderated from their strong fourth-quarter readings. On a 12-month basis, both overall inflation and inflation for items other than food and energy are close to having continued to run below 2 percent. Market-based measures of  inflation compensation have increased in recent months but remain low; survey-based measures of longer 

term inflation expectations are little changed, on balance. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The economic outlook has strengthened in recent months. The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong. Inflation on a 12-month basis is expected to move up in the coming months and to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced. , but the Committee is monitoring inflation developments closely. 

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to the Committee decided to maintain the target range for the federal funds rate at 1-1/2 to 1-3/4 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and inflation near its 2 percent objective. a sustained return to 2  percent inflation. 

In determining the timing and size of future adjustments to the target range for the federal funds rate, the  Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information,  including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that 

economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. 

Voting for the FOMC monetary policy action were Jerome H. Powell, Chairman; William C. Dudley, Vice  Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Loretta J. Mester; Randal K. Quarles; and John  C. Williams.

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