Get to Neutral Without Delay, Then Be Very Careful

Since the May FOMC meeting, we adjusted our fund’s rate call, removing a hike in 2019 based on our expectation that the FOMC is likely to pause once the funds rate reaches its estimated neutral level, in mid-2019. This change was informed in part by policymakers’ public remarks, which indicated that they are likely to approach further rate hikes much more cautiously once at neutral and not by any change in the economic outlook, which remains very strong. Trade remained a major issue dominating discussions of the economic outlook, but it remains largely a downside risk to the forecast, and to this point was not seen as hurting the baseline forecast. A resurgence of concern about the future of the euro area, this time regarding Italy, also entered as a risk factor. But policymakers remained unambiguously upbeat about the economic outlook, and the substantial decline in the unemployment rate since the last FOMC meeting only reinforced the need to move monetary policy to a neutral stance. However, policymakers did not express significant concern about getting too far behind the curve and inflation rising substantially above its objective, and they indicated that they would be very comfortable with core inflation overshooting the 2 percent objective by a modest amount.  

Policymakers saw the economic outlook as strong and seemed to see the risks as balanced. Governor Brainard said, “In short, with a tightening labor market and inflation near target, fiscal stimulus in the pipeline suggests some risk to the upside. By contrast, recent developments abroad suggest some risk to the downside” (5/31).  These global developments posing downside risks included renewed political uncertainties in the euro area,  specifically Italy, financial stresses in emerging markets, and uncertainty over trade. Chair Powell’s comments  (5/8) about the global effects of U.S. monetary policy were consistent with our view that international stresses will affect policy only to the extent they affect the U.S. economic outlook. He said that “markets should not  be surprised by our actions if the economy evolves in line with expectations.” 

Governor Brainard has long entertained the possibility that there might be more slack in the labor market than  indicated by comparing the U-3 unemployment rate to its historical levels, and she reiterated that “it is difficult  to know with precision how much slack still remains.” However, she said, “I am seeing more evidence that  labor markets are tightening, and wages are accelerating, although at a measured pace.” While she had seen  some acceleration in wages, she said, “Going forward, I will be looking for confirmation in other measures of  wages that labor market tightness is feeding through to wage gains.” Policymakers continued to point to the lack of a stronger acceleration in wage growth as a reason that they weren’t concerned about the economy overheating excessively. Williams (5/16) said it’s “a serious reason, that I’m not that worried about inflation,  or wage inflation, or price inflation, being on the cusp of an outburst.” Policymakers who have leaned dovish,  including Presidents Kashkari (5/17) and Bostic (5/17), thought that wage growth would be much stronger if the labor market were really as tight as the low unemployment rate would suggest. President Mester (5/14)  said that wage growth was “not a mystery if you think about low productivity growth.” 

There was a strong consensus among policymakers, as there has been for some time, that monetary policy should be brought to a neutral stance at about its recent “gradual” pace. The discussion is now centered on where neutral is and how the FOMC should proceed once that point is reached. Governor Brainard (5/31)  characterized the outlook for monetary policy this way: “This outlook suggests a policy path that moves  gradually from modestly accommodative today to neutral–and, after some time, modestly beyond neutral– 

against the backdrop of a longer-run neutral rate that is likely to remain low by historical standards.” We saw  

this characterization as consistent with our view that the FOMC will raise rates once per quarter, at each meeting with a press conference, until the funds rate is near its estimated neutral level. The line that the fund’s rate will then move past neutral “after some time” seems consistent with the FOMC pausing, at least briefly, once at neutral.  

Other policymakers also acknowledged that monetary policy would likely need to be brought into the restrictive territory but wanted to proceed very cautiously. Comments from President Williams, a centrist, indicated there is likely to be a fairly high bar for accelerating the pace of rate hikes. In particular, he expressed very little concern about a modest overshoot of inflation: “this idea that it might overshoot by a few tenths, that wouldn’t bother me too much. But obviously, if we see the inflation pressures, wage pressures, all starting  to build, that would argue for a somewhat faster tightening of monetary policy.” Some, such as Presidents  Harker and Kaplan, expressed even greater skepticism about raising the fund’s rate past neutral. President  Harker (5/21) said, “Let’s get to neutral and see how things play out, I would prefer to not be contracting the  economy.” President Kashkari (5/21) likewise argued for pausing at neutral. President Kaplan (5/25) said,  “I’m not prepared yet to say I want to go above neutral. I think once we get there, we’ll have to make that  judgment at that time, whether it makes sense to be restrictive.” There continued to be a lack of a vocal  hawkish contingent. President Mester (5/23), who we’ve seen as to the hawkish side of center in general,  warned against monetary policy becoming “overly restrictive.” Even President George (5/4) appeared to be  comfortable with an overshoot, saying that a steeper path of rate hikes would be warranted if inflation rose  above 2.3% 

Policymakers generally saw the longer-run funds rate like 3% or lower and expected the fund’s rate to near its neutral level quite soon. President Harker (5/24) saw the longer-run level as 2.75% to 3%, which seemed to remain the consensus among FOMC participants. President Kaplan (5/25) argued that “After three or four  more moves, we’re going to be at neutral.” He saw the neutral level as between 2.5% and 2.75%. Those policymakers who commented specifically on the path of the fund’s rate this year did not indicate a  meaningful shift in their views. President Harker (5/21) continued to advocate three hikes this year, as did  President Bostic (5/16). President Williams continued to say that three or four rate hikes would likely be appropriate this year. He said, “a long-term rate of r-star of between zero and one percent is likely going to  be with us for a long time.” 

Policymakers’ comments that monetary policy is approaching neutral, and the discussion in the minutes about problems with the FOMC statement’s characterization of the stance of monetary policy as accommodative,  suggested that the FOMC is exploring a more substantial rewrite of the statement at this week’s meeting.  President Brainard’s (5/31) characterization of monetary policy as “modestly accommodative today”  previewed a possible change in the post-meeting statement that is certainly under consideration at this week’s meeting. President Williams, referring to the “accommodative” wording in the statement, noted, “We’re still  accommodative, interest rates are still below long-run levels, but over the next period of time, we’ll have to  revisit that.” More generally, Chair Powell (5/25) said he saw a “significantly smaller” role for forwarding guidance in the future. 

Policymakers continued to discuss the relevance of the shape of the yield curve to monetary policy and, in particular, the prospect of a yield curve inversion. However, many of the same policymakers, Presidents  Bostic, Kaplan, Harker, and Kashkari, reiterated previously stated concerns about yield curve inversion, and there didn’t seem to be any broader consensus forming or change in the narrative. President Kaplan (5/25)  saw the shape of the yield curve as a central consideration in near-term his monetary policy views: “I’m going to be watching very carefully the shape of the yield curve. That’s the reason why I’m saying let’s just keep  the base case for this year at three.” President Bostic went so far as to say, “We are aware of [the inversion risk]. So it is my job to make sure that doesn’t happen.” 

President Mester, in contrast, downplayed concerns about the shape of the yield curve: “Just because the  yield curve is flat does not necessarily mean lower growth or even a recession; there are a number of good  reasons why the yield curve is currently flat.” Governor Brainard (5/31) discussed the topic in some depth in  her speech, acknowledging that, “Historically, yield curve inversions have had a reliable track record of 

predicting recessions in the United States.” However, she argued that “With the term premium today very  low by historical standards, this may temper somewhat the conclusions that we can draw from a pattern that  we have seen historically in periods with a higher term premium.” President Williams had previously expressed concern about the prospect of a yield curve inversion but then downplayed that concern. He reiterated that he is not greatly concerned: “Am I worried today about the fact the yield curve is flat? No. Because I think that’s driven primarily by the fact that the Fed is tightening, long rates are moving up, but not surprisingly,  not one-for-one…I don’t see that as a situation that we would be running into in the next year or so, but I  think the answer to that depends on the context.” He added that he “definitely wouldn’t ignore signals we’re  getting from the markets.” 

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