Fed Round-Up For September 7, 2017, by Tim Duy: Federal Reserve hawks were on the march today, laying the groundwork for an additional rate hike this year despite weak inflation.
First off, Cleveland Federal Reserve President Loretta Mester (voter next year), reiterated the “it’s only temporary story” regarding inflation:
In assessing where we are relative to the inflation goal, it’s always a good idea to look through temporary movements in the numbers, both those above and those below our goal, and focus on where inflation is going on a sustained basis. For example, when assessing the underlying trend in inflation, we should look through a temporary increase in gasoline prices stemming from disruptions caused by Hurricane Harvey. Similarly, some of the weakness in recent inflation reports reflects special factors, like the drop in the prices of prescription drugs and cell phone service plans earlier in the year. It may take a couple more months for these factors to work themselves through, but these types of price declines aren’t signaling a general downward trend in consumer prices from weak demand. Instead, they reflect supply-side factors and relative price changes.
She did give a nod to Federal Reserve Governor Lael Brainard’s argument that maybe trend inflation has fallen:
At the same time, we need to recognize that weak inflation numbers, no matter what the source, can become a problem if they start to undermine the public’s expectations about future inflation. If inflation expectations were to become unanchored and began steadily declining, it would be much more difficult to raise inflation back to the Fed’s goal.
But she doesn’t buy it:
I don’t expect the economy to get to that point, and my current assessment is that inflation will remain below our goal for somewhat longer but that the conditions remain in place for inflation to gradually return over the next year or so to our symmetric goal of 2 percent on a sustained basis. These conditions include growth that’s expected to be at or slightly above trend, continued strength in the labor market, and reasonably stable inflation expectations.
On the inflation forecast, this is interesting:
We need to recognize that there are risks around any inflation projection—both upside risks, considering the current and future expected strength in labor markets, and downside risks, given the softness in recent inflation readings. In fact, inflation is difficult to forecast: based on historical forecast errors over the past 20 years, the 70 percent confidence range for forecasts of PCE inflation one year ahead is plus or minus 1 percentage point, and a significant portion of the variation in inflation rates comes from idiosyncratic factors that can’t be forecasted. Indeed, since the 1990s, assuming that inflation will return to 2 percent over the next one to two years has been one of the most accurate forecasts. In the recent period, this is perhaps a testament to the importance of well-anchored inflation expectations and of the FOMC’s commitment to its 2 percent symmetric inflation goal. In any case, I will be scrutinizing incoming data on inflation and inflation expectations and the reports from my business contacts to help me assess the inflation outlook.
Since 1990, a 2 percent forecast has worked more than not, so lets just stick with that as the baseline for policy? By that logic, since the great recession, a 1.75% forecast has worked more than not, a testament to the Fed’s one-sided inflation target and falling inflation expectations. I am not buying into her inflation forecast story yet.
Regardless, Mester’s commitment to the faith on the inflation forecast means that as of now, she is probably sticking with the current rate path, including a December hike.
Meanwhile, FOMC heavyweight New York Federal Reserve William Dudley stuck to his guns as well tonight. His basic outlook:
Overall, the economy remains on a trajectory of slightly above-trend growth, which is gradually tightening the U.S. labor market. Over time, this should support a rise in wage growth. When combined with a firmer import price trend—partly reflecting recent depreciation of the dollar—and the fading of effects from a number of temporary, idiosyncratic factors, that causes me to expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term. In response, the Fed will likely continue to remove monetary policy accommodation gradually. But, the upward trajectory of the policy rate path should continue to be shallow, in part because the level of short-term interest rates consistent with keeping the economy on a sustainable long-run growth path is likely to be considerably lower than it was in prior business cycles.
Dudley, however, will continue watching the inflation numbers, looking for this story:
If it turns out that structural changes have played a significant role, I would generally view this as a positive, rather than negative, development. It would imply that the U.S. economy could operate at a higher level of labor resource utilization without generating a troublesome large rise in inflation. More people could be put to work on a sustainable basis, enabling them to gain opportunities not just to earn greater income, but also to develop their skills and grow their human capital.
This opens up a downward revision of estimates of the natural rate of unemployment. Still, he thinks the Fed should continue hiking rates, in part due to easing financial conditions:
This judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the Fed has raised its short-term interest rate target range by 75 basis points since last December.
Yep, this is an expected response from Dudley. So is his pushback on inflation concerns:
In addition, the long and variable lags between monetary policy adjustments and their impact on the economy imply that the FOMC may need to remove accommodation even when inflation is below its goal. In particular, if the unemployment rate were already below its longer-run natural rate, as may be the case currently, the impact on wage growth and price inflation would still likely take some time to become evident.
But, OMG, he follows up with this:
This would be particularly true if inflation expectations were well-anchored at or slightly below our 2 percent objective, as is the case currently.
Brainard strikes again! But notice that HE SEES IT AS MORE LIKELY THAT INFLATION EXPECTATIONS ARE BELOW THAN ABOVE TARGET! One would think this would give him a bit more concern before pushing forward with more rate hikes, but no.
Fundamentally, Dudley wants to keep hiking as long as financial conditions keep easing.
That’s enough on Fed speakers for now. Time to return to yesterday’s topic of new Fed appointees. This from Bloomberg:
The White House is considering at least a half-dozen candidates to be the next head of the Federal Reserve, including economists, executives with banking experience and other business people, according to three people familiar with the matter.
The breadth of the search goes against the narrative that has taken hold in Washington and on Wall Street that the Fed chair nomination is a two-horse race between National Economic Council Director Gary Cohn and current Fed Chair Janet Yellen, whose term expires in February.
Some of the other possible contenders include former Fed Governor Kevin Warsh, Columbia University economist Glenn Hubbard and Stanford University professor John Taylor, one of the people familiar said. Lawrence Lindsey, a former economic adviser to President George W. Bush, has been discussed. Former US Bancorp CEO Richard Davis and John Allison, the former CEO of BB&T Corp., have also been considered.
This doesn’t sound good for Yellen. Sounds like a wide-open field that will keep us guessing for weeks.
Separately, on the data front, we get this from Commerce, via Reuters:
The U.S. economy probably grew faster than reported in the second quarter, with data on Thursday suggesting stronger consumer spending than previously estimated.
The quarterly services survey, or QSS, from the Commerce Department implied consumer spending increased more briskly than the 3.3 percent annualized rate reported last week in its second estimate of gross domestic product.
The Fed forecasts are based on more modest growth numbers. Stronger growth numbers will tilt them toward further rate hikes.
On the other hand, the anecdotal evidence via the Beige Book was less optimistic. In that read of the economy, activity was only modest to moderate with limited wage and inflation pressures. That said, I tend to believe that data trumps anecdotal evidence when it comes to policy.
Bottom Line: Hawks are still pushing for additional rate hikes, holding to the story that low inflation is all about transitory factors. This I think remains the dominant position on the FOMC. For what its worth, market participants do not believe this is how it will play out. The odds of a December rate hike are now hovering around 25%. Markets participants are not seeing the same story as most central bankers. Something’s gotta give.