Plenty to Say, But Not in the Statement

It’s a foregone conclusion that there won’t be a rate hike at the November FOMC meeting, so we turn our attention immediately to December. 

▪ We expect minimal changes to the statement. The incoming economic data don’t require significant adjustments to the language, and we don’t see much chance of an acknowledgment of recent financial market volatility given the dovish connotations that would have.  

▪ We also don’t see much likelihood at this meeting of changes to the “further gradual” wording (for example, to Clarida’s “some further gradual adjustment”).  

▪ A December hike, while not a done deal, is highly likely. 

▪ There is a consensus within the Committee that the immediate task is removing accommodation, and a  hike in December is the next step. 

▪ This is also the last meeting that is not accompanied by a press conference. Chairman Powell will hold press conferences following every single FOMC meeting in 2019.  

So, our focus turns to the second half of 2019, when the Committee will be wrestling with whether to move into restrictive territory. 

▪ The consensus (SEP) supports moving into the restrictive territory: Two more moves, or 50 basis points,  beyond the median estimate of the longer-run fund’s rate. 

▪ The question, though, is what the economy and the forecast will look like by then. 

This is where key features of our and participants’ forecasts come into play. 

▪ First, growth steadily slows, with the slowing becoming clearly evident by the second half of 2019. ▪ Second, growth slows to below trend by late 2020 or 2021, with the unemployment rate beginning to rise. This doesn’t usually end well. 

▪ This raises an interesting question: Will the Committee revise its projected appropriate rate path if growth continues to slow as projected and we get closer to when they expect the unemployment rate to begin to rise? 

On the other hand, the case for further increases is consistent with recent upward revisions to estimates of r-star by some participants. 

▪ Some raised their estimates because they believe the short-run r-star has risen above the longer-run  measure. 

▪ Others raised theirs because estimates of r-star derived from financial markets suggest that r-star may be closer to 3.5% than 3%. 

Our call is unchanged: four hikes in 2018 and three hikes in 2019. But we see two hikes in 2019 as much more likely than four. 

▪ We expect the Committee will continue to raise rates at every other meeting until they’ve raised the fund’s rates as far as they intend to raise it, which means no pauses along the way. 

▪ We believe the consensus will be to make the final move in September 2019. 

The Outlook Context 

The economy appears to have solid momentum in the second half of this year, but we expect a sharp slowing in growth next year. Given that we expect the funds rate will reach the median estimate of r-star in mid-2019, the incoming data and the forecasts at the  September and December meetings of next year will determine whether the FOMC  continues to raise rates after having reached the median estimate of the neutral rate. So, 

we focus on this period.  

Steeply Slowing Growth in 2019 

First, let’s look at the GDP report for Q3 and implications for Q4. OK, we hit real GDP growth on the nose,  3.5%. But the composition was different than we expected in our last forecast, from around the time of the  September FOMC meeting. On balance, however, the composition of real GDP in Q3 has not meaningfully altered our expectations of growth in the fourth quarter and beyond. 

Financial Conditions 

Financial conditions have become less accommodative since the September meeting, the key change is a  substantial decline in equity prices. These changes suggest a slighter lower path of growth than in our last forecast. Simulations using FRB/US suggest several tenths lower growth spread over 2019 and 2020. This is a meaningful change, but not enough at this point to change the basic contours of the outlook underpinning our fund’s rate call. Equity prices remain at high levels, and consumer spending has shown no sign of slowing down. It does shift the risks around our call of three hikes in September 2019 further toward only two hikes,  however.  

How Low Will the Unemployment Rate Go and Does that Matter for Inflation? 

Employment growth is strong, with no clear signs of slowing. The unemployment rate fell to 3.7% in  September and remained there in October (link). We expect it will fall further, to below 3½% around mid-2019. The question is the link to inflation. Doesn’t seem to be any yet. Perhaps the NAIRU is lower than the median estimate. In any case, the very flat Phillips curve and stable inflation expectations are keeping a lid on inflation, so far. By the end of 2019 inflation is likely to be at or marginally above 2%, and many or most participants believe it will remain in that range through at least 2021. In that case, there will be little appetite for bringing the funds rate much beyond the median estimate of neutral, and there will be a vocal camp favoring stopping at neutral, pending an upward trend in inflation in the data. This is the return of the “show me the inflation” camp. 

The Stars 

Estimates of r-star and the NAIRU remain guideposts for monetary policymakers, even for those who emphasize the uncertainty surrounding these estimates. We see downward bias to estimates of the NAIRU,  upward bias to the estimates of r-star, and upward bias to estimates of potential growth. 

If inflation remains near 2% into 2019, with the unemployment rate materially below the prevailing estimate,  we expect that the median estimate of the NAIRU will fall below 4½%, by the end of 2019 at the latest. 

There is an upward bias to the median estimate of potential growth, which is still 1.8%. The CBO has raised its estimate to 2%-2.1% for 2018-2021, though its estimate ten years out is still closer to 1¾%. We think the median estimate will soon edge up toward the CBO’s medium-term estimate. A few on the Committee who expect a near-term boost to productivity growth from the Trump tax cuts will lead the way, perhaps raising their estimates to above 2%. Faster growth in potential typically passes through quickly to actual growth,  removing any effect on the output gap. But faster growth in potential also passes through to r-star, in which 

case there is further to hike to get to r-star. In addition–as we learned in the second half of the 1990s–an unanticipated upward move in underlying productivity is a disinflationary shock that lowers the near-term  NAIRU, allowing the economy to grow above its trend rate without inflationary pressure. 

There is also an upside risk to r-star. First, the estimate of r-star from the Laubach-Williams model has increased ¾ percentage point, to near 3% (nominal), perhaps encouraging the few participants below the median to rise toward the median. There has been discussion about a different way of estimating r-star by extracting it from TIPS. Those estimates are higher than 3% (3.5% to 3.75% was implied). A few participants have talked about a short-run neutral that is higher than the long-run neutral. Similar to how headwinds lowered short-run r-star previously, tailwinds today are raising short-run neutral above its longer-run level.  And then there are the supply-siders who talk about faster productivity growth, which would pass through to a higher r-star. We are still at 3%, in line with the median estimate of participants. 

FOMC Call 


No need to talk about the November meeting in-depth. So, we turn to December, where we see a hike as a  very high probability. The Committee is committed to removing accommodation (despite disagreement over where neutral is) and that means another hike in December. The economic outlook and forecast are very likely to support this. Recent volatility in financial markets, and specifically the decline in equity prices, will not lead anyone to suggest a retreat to risk management, in the form of a December pause. Not a chance. 

Go to Neutral 

We expect the FOMC to continue to raise rates 25 basis points at every other meeting until they reach the median estimate of r-star, currently 3%. We assume they will reach the central tendency range of participants’ estimates of neutral, 2¾%-3%, in June 2019. While the slowing trend in growth will already be evident, we expect growth will still be seen as comfortably above potential, suggesting a further decline in the unemployment rate. These developments would support a rate hike in June 2019. 

After Neutral 

The dominant view on the Committee is that the FOMC should continue to raise the fund’s rate modestly above neutral, to 3½%. Still, a number will be reluctant to do so as long as inflation is not above 2% and not on a rising trend. And that is what we expect in the second half of 2019. This is the return of the “show me the inflation” camp. So, there will be a serious debate about whether to hike again in September 2019.  

Now, we could say that this would be just what the doctor ordered, growth only modestly below trend–no recession–with the unemployment rate rising very slowly toward the estimated NAIRU. That seems to be what is in participants’ rate projections. A soft landing from growth above potential. Let’s face it, achieving such an outcome is very difficult.  

The historical record shows that, when the unemployment rate rises even by a couple of tenths, it does not end well; this is almost always associated with a recession. In addition, we have said that risk management calls for tilting toward avoiding a recession, rather than trying to avoid higher-than-desired inflation. We had questioned whether the FOMC would consider such a projected increase in the unemployment rate to be consistent with appropriate policy. However, the September median projection showed just this. Still, there will be a lot of discomfort with such a scenario if policymakers are actually faced with it.  

To Restrictive Posture or to a Higher Neutral Rate 

Ahead of this FOMC meeting, given our thinking about a downward revision in the growth outlook due to the deterioration of financial conditions, we did consider taking out one hike, so the fund’s rate would not move into restrictive territory. But it would be premature to do that solely because of this movement in equity prices. So, we continue to expect one more hike past neutral, in September next year, bringing the tightening cycle to an end.  

First, we see this small move into restrictive territory as insurance against an undesirable rise in inflation, so that the FOMC can be seen as leaning against an upward trend in inflation if it moves above 2%. Second,  the concept of a short-run r-star has reemerged, but with a twist. Some participants, notably Brainard, have suggested that tailwinds today are raising the short-run r-star above its longer-run level, just as tailwinds were previously seen as lowering the short-run r-star below its longer-run or normal level. Third, alternative indicators of r-star, extracted from the TIPS market and cited by a couple of participants, suggest that r-star could be as high as 3½% today.  

The Statement 

Powell prefers a shorter statement. This, in effect, elevates the dots’ role in providing forward guidance,  perhaps as an unintended consequence. So, we expect an unexciting statement after next week’s meeting,  as we await the December dots. We expect minimal changes to the first paragraph, just enough to reflect the incoming data, specifically the latest decline in the unemployment rate and the moderation in business fixed investment in Q3. We also consider possible changes in two areas, neither of which we see as likely: some acknowledgment of the change in financial conditions since the last meeting and a change to the “further gradual” wording. 

It is possible the November statement might acknowledge the drawdown and volatility in equities, which has some similarities with 2015/2016 episodes, but it’s not our base case. In 2015 and 2016, drawdowns in the  S&P 500 of similar magnitude to this episode made the FOMC assign special significance to recent financial developments. In contrast, the current drawdown episode comes after a period of prolonged and sustained equity gains. In addition, the U.S. economy is in a very different position. 

One problem with adding a special reference to financial markets is that it sounds dovish. It suggests that the  FOMC would slow its pace of rate hikes in response. But policymakers likely don’t see any need to make market expectations, for 2019 and beyond, any more dovish than they currently are. And the odds for a  December hike would be pushed lower than desired, though all but the most steadfast doves support a  December hike. 

For a long time, the statement has included the boilerplate wording (“will take into account… readings on  financial and international developments”), and this sentence will remain. 

Changes to “Further Gradual” Wording Unlikely 

Clarida saw “some further gradual adjustment” in the fed funds rate as appropriate. This wording differs from the “further gradual increases” in the FOMC statement in two ways. First, adding “some” suggests that rate hikes are nearly over. Second, using “adjustment” rather than “increases” could sound like the FOMC is moving away from the concept of a definite series of moves (“increases”) to a less-committal, more meeting by-meeting approach to further hikes. We don’t see Clarida’s use of this wording as necessarily being an indication that “some” will be added to “further gradual” in the November FOMC statement. This would be dovish and perhaps undesirably so. 

Our statement guess:  

Information received since the Federal Open Market Committee met in September August indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low declined.  Household spending and business fixed investment have grown strongly have continued to grow strongly,  while the growth rate of business fixed investment has moderated. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators 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 Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced. 

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 maintain the target range for the federal funds rate at 2 to 2-1/4  percent. 

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 maximum employment objective and its symmetric 2 percent inflation objective. 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. 

Voting for the FOMC monetary policy action was: Jerome H. Powell, Chairman; John C. Williams, Vice  Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Richard H. Clarida; Mary C. Daly; Esther L.  George; Loretta J. Mester; and Randal K. Quarles. 

IOER Adjustment 

Remarks from Potter (Markets Group chief) and reserve bank presidents suggest a greater likelihood of another  IOER adjustment soon. The strongest indication came from Potter’s speech: “Another technical adjustment  to the IOR rate…could be used to foster trading in the federal funds market at rates well within the FOMC’s  target range.” This shows continued faith in adjusting IOER to anchor fed funds. We interpret “well within”  to mean at least 5 basis points below the upper bound. Our base case is that the next adjustment will occur in December, with an IOER hike of less than 25 basis points. But November is a possibility. The November minutes would prepare the market for a presumptive December change.

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