Staying the Course

The basic contours of our expectations for the economic outlook and for monetary policy remain in place. 

▪ Growth remains well above trend and will gradually slow toward trend by 2020. The unemployment rate will decline further below the NAIRU, to 3½% by the end of 2019. 

▪ On core inflation, we differ from FOMC participants. The median projection for 2020 is 2.1%. Despite an unemployment rate projected to be 3.5% at that time (a percentage point below the NAIRU), the project that inflation will essentially be stable at its objective. We expect core inflation to gradually firm, reaching  2¼% in 2019 and 2020 (modestly above the objective). 

▪ We expect the FOMC to proceed with rate hikes at a pace of one per quarter until the fund’s rate reaches its estimated neutral level—approximately 3%—in June 2019. Both we and the FOMC expect the fund’s rate to be raised about 50 basis points above its neutral level by the end of 2020. 

The issue is whether—with what FOMC participants currently project to be appropriate policy—inflation near  2% will be compatible with an unemployment rate so far below the NAIRU. 

▪ Apparently, policymakers see these macro outcomes as compatible. This follows in part from the current flatness of the Phillips curve. That flatness leads to a very modest rise in the inflation rate even with an unemployment rate a percentage point below the NAIRU. 

▪ Policymakers also appear to believe that we are no longer in an accelerationist world, in which such a low unemployment rate would lead to progressively higher inflation. 

The first task on the agenda is to continue a gradual course of rate hikes toward the neutral level. That means three or four hikes per year through 2019. 

▪ Our call is that there will be four hikes in 2018 and three hikes in 2019. 

▪ Notwithstanding the uncertainty about the neutral rate, the Committee seems to be comfortable using their estimate (2.75% to 3%) to guide them. 

But an outstanding question is what the Committee will do once the funds rate reaches neutral. 

▪ The median projected path has the FOMC continues to raise the funds rate above the neutral rate, or into restrictive territory. That’s also what we expect. 

▪ But, at that point, the incoming data will become more important, and the forecast less important. 

▪ As the fund’s rate rises toward neutral (until mid-2019), growth will continue to be above trend. But, by  2019:Q2, growth will be slowing. The unemployment rate is also projected to stabilize at that time. 

▪ With core inflation still at 2%, there will be a debate about whether or not to pursue further rate hikes  (given that such hikes could precipitate a recession) and whether further tightening is warranted to keep inflation near 2% in 2020. 

Discussion on balance sheet normalization and the longer-run operating framework will resume. 

• To be sure, these discussions are unlikely to be reflected in the FOMC statement. Instead, they will be described in the minutes. 

• Assuming the FOMC wants to remain in the current operating regime (floor system), the issue is the size of the balance sheet required to keep the fund’s rate comfortably inside its target range. 

• The longstanding principle has been that the balance sheet should be large, but only large enough to control the fund’s rate effectively. 

• It appears that the size of the balance sheet compatible with effective control of the fund’s rate is larger than previously anticipated. 

• The FOMC will be pressed to make official its decision on the operating regime because it appears that the balance sheet will reach a normalized size earlier than previously anticipated—late in 2019, rather than in 2020. 

The Outlook Context 

Not much change in the outlook since the June meeting and forecast (See our commentary). Real GDP growth came in at 4.1% in Q2, somewhat stronger than anticipated, with little change in the outlook beyond that.  The unemployment rate has risen a couple of tenths but was accompanied by a two-tenth rise in the participation rate. More importantly, the pace of job gains remains robust. The core macro question is whether an unemployment rate so far below the NAIRU is compatible with meeting the inflation objective. 

FOMC Call 

The August 2018 meeting will have no rate hike, of course. Nevertheless, the debate on which rate-hike path to pursue will continue. We see the Committee as seeing the immediate task as moving toward a neutral funds rate setting, about 3% as indicated by FOMC participants’ projections. The trajectory of rate hikes beyond  3% (or mid-2019) is more uncertain and will be vigorously debated. In mid-2019, the question will be whether the incoming data still show inflation steady at 2% and whether the forecast (as is the case now) will still have inflation (in effect) at the 2% objective in 2020. We will have a better idea of the FOMC’s mindset after the September FOMC meeting, which will introduce macro and rate projections for 2021 for the first time.  Those projections will reveal key insights into the FOMC’s assumptions about 2021: how much further growth slows (likely to below trend), whether the unemployment rate begins to rise toward the NAIRU, and how much above 2% core inflation is in 2021. 

After Reaching Neutral 

We see the path of the fund’s rate after it reaches neutral as the key issue, especially with Powell’s wariness of point estimates of the neutral fund’s rate and the NAIRU and his emphasis on learning about these thresholds—which are truly very uncertain—from the incoming data. 

We may see once more the split on the Committee between two divergent viewpoints: the “show me the inflation” camp and the “initial conditions and forecast” camp. Whether there’s a split may depend on whether their forecast projects inflation above 2% even when the incoming data show no signs that core inflation has moved (or is about to move) above 2%. 

According to the median projection of FOMC participants, core inflation in 2019 and 2020 will be 2.1%. So,  in mid-2019, core inflation is projected to still be around 2%. If the Committee is effectively at its inflation objective through its forecast horizon, why would the Committee continue to raise rates to above neutral?  The answer might be that inflation remains contained precisely because the fund’s rate is overshooting neutral,  by ½ percentage point by late 2020. The Committee, of course, has plenty of time to form a firmer judgment on this.

The Balance Sheet: An Active Topic Once More 

The June minutes said “a few” suggested that a discussion on optimal monetary policy implementation when  reserve balances fall appreciably lower should resume “before too long.” The FOMC has not settled on a  longer-run framework but Powell said it will resume considering the issue seriously “fairly soon.” 

The major question is when the balance sheet will shrink to what the FOMC considers a normalized size. It has been upfront about not knowing for sure what the size will be. Rather, it has said it would learn from its experiences as the normalization plan proceeded and the runoff caps increased. Importantly, a key goal is to maintain control over the effective federal funds rate so it trades within the target range. A recent problem has been the fund’s rate trading much higher than the midpoint of the target range. That was the impetus for the adjustment in the IOER rate—from the upper bound of the fund’s rate target range to five basis points below the upper bound. But the IOER rate is not the principal cause of the behavior in funds rate trading.  Rather, recent increases in Treasury bill issuance and possibly regulatory factors were key causes. 

Surveys of market participants, which are taken seriously by policymakers, recently showed increases in the expected equilibrium size of the balance sheet and the level of reserves required to keep the fund’s rate trading in an acceptable range. These results point to an earlier end to runoff and a normalized balance sheet that was larger than previously anticipated. It will likely be a topic of discussion at the meeting, informed by a  staff presentation. These details would be described in the August FOMC minutes. 

The Message in the Statement 

We expect minimal changes to the post-meeting statement, given that it received a substantial rework in June and there is no press conference following this meeting. But the first paragraph will need to be changed to reflect the incoming data. 

There are two possible changes in the first paragraph. 

1. The unemployment rate rose 0.2 pp and the participation rate rose 0.2 pp in June, while job gains remain robust. The FOMC must adjust the language on the unemployment rate. But the statement usually doesn’t refer to the participation rate. 

2. Incoming data led to upward revisions to estimates of Q2 growth, and the advance estimate came in at 4.1%. There could be some adjustment of the language to reflect this but it is not really necessary. 

We are not really sure how exactly the FOMC will adjust the language to reflect the recent data on the unemployment rate! In the past, when the unemployment rate has edged up, the FOMC has used the line,  “the unemployment rate is little changed in recent months.” But that line doesn’t seem appropriate now, since the month-to-month moves have been larger, even if on the net the unemployment rate is little changed. In our statement guess below, we have the FOMC acknowledging the increase in the unemployment rate since the previous meeting but reinstating language saying that the unemployment rate remains low. 

The statement is unlikely to incorporate the qualifying phrase “for now” that Powell included in his description of the FOMC’s prevailing expectation of the appropriate policy path in his prepared remarks for his semiannual testimony. In our view, “for now” did not necessarily signal a slower-than-anticipated pace of rate hikes.  Rather, it was intended to underscore the conditional (or data-dependent) aspect of the FOMC’s rate-path plans. This sentiment is already reflected in the existing wording. Furthermore, the market would read too much into such a revision.

No changes in the rest of the statement—other than about the decision to hold rates steady and in the names of the voters.1 The FOMC chose to keep the line “the stance of monetary policy remains accommodative” in the June post-meeting statement despite making other significant revisions, so it’s extremely unlikely to change it now. 

The Statement 

Information received since the Federal Open Market Committee met in June May indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. The unemployment rate increased but remains low, and job gains have been strong in recent months. Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Recent data  suggest that growth of household spending and has picked up, while business fixed investment have grown 

has continued to grow strongly. On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 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 maintain the target range for the federal funds rate at raising the target range for the federal funds rate to 1-3/4 to 2 percent.  The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and 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 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 were Jerome H. Powell, Chairman; John C. Williams William C. Dudley, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Esther L. George; Loretta J.  Mester; and Randal K. Quarles; and John C. Williams.

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