Tuesday, April 17, 2018

Fed Still on Gradual Normalization Course

The word “inflation” appears 106 times in the minutes of the latest FOMC meeting, held March 20-21 and released on April 11. By contrast, the word “unemployment” appears 45 times. Does this suggest that Fed officials are increasingly concerned about a rebound in inflationary pressures given that the jobless rate was at a cyclical low of 4.1% during March? There were still 6.6 million unemployed workers, according to the Bureau of Labor Statistics (BLS). However, the latest data, also from the BLS, showed that there were 6.1 million job openings during February. That implies that virtually all the remaining unemployment can be described as “frictional,” resulting from geographic and skills mismatches.

Actually, Fed officials have been rooting for inflation to rise to their 2.0% target for the yearly percent change in the personal consumption expenditures deflator. They first publicly announced this target at the start of 2012. Yet much to their chagrin, they have failed ever since then to boost inflation on a sustainable basis to 2.0% despite their ultra-easy monetary policies following the Great Recession.

Nevertheless, the FOMC started to normalize monetary policy, first by ending quantitative easing at the end of October 2014, then by gradually raising the federal funds rate in 25-basis-point baby steps—starting from around zero at the end of 2015 to 1.50%-1.75% at the March meeting.

They are likely to remain on this gradual course through next year, since the latest economic projections of the FOMC participants show median inflation expectations of 1.9% this year and 2.0% next year. Anticipating finally accomplishing their mission of hitting their inflation target, the committee’s median projections for the federal funds rate are 2.1% at the end of this year and 2.9% at the end of next year.

Financial markets started to fret about a more aggressive normalization of monetary policy on February 2, when January’s employment report showed a higher-than-expected 2.9% gain in wages, as measured by average hourly earnings for all workers. That’s a bit ironic given that during Janet Yellen’s first press conference as Fed chair during March 2014, she suggested that the Fed’s easing-does-it policies would bring wage inflation back up to a range of 3.0%-4.0%.

Four years later, following last month’s FOMC meeting, Fed Chair Jerome Powell signaled in his first press conference that monetary normalization would remain on a gradual course. March’s wage inflation rate eased to 2.7%. The minutes released last week sent a message to financial market participants to chill out about inflation.

The message seemed to be a response to the observation in the minutes that “a steep” albeit temporary “decline in equity prices and an associated rise in measures of volatility” resulted from market participants’ reaction to “incoming economic data released in early February—particularly data on average hourly earnings—as raising concerns about the prospects for higher inflation and higher interest rates.”

FOMC participants do expect that inflation will rise as “transitory” factors that had weighed on inflation last year dissipate this year. Furthermore, the stronger economic growth is expected to push inflation up toward the FOMC’s 2.0% objective, according to the minutes. But such an increase is not expected to change the FOMC’s gradual course of raising interest rates. Nor would a temporarily overshoot of the inflation target: “A few participants suggested that a modest inflation overshoot might help push up longer-term inflation expectations and anchor them at a level consistent with” the FOMC’s 2.0% objective.

If inflation should rise much faster than expected and stay consistently above 2.0%, however, then the FOMC might decide to raise rates at a “slightly” faster pace over the next few years. One risk to inflation discussed in the minutes could come from fiscal stimulus. Depending on the timing and magnitude of the effects of fiscal stimulus, it could push output above its potential and further tighten resource utilization.

Fed policy isn’t likely to veer much from the current course of normalization. President Donald Trump seemed to signal his endorsement of this course by promoting Fed Governor Powell to replace Yellen. The President just announced his intention to nominate Richard Clarida for the No. 2 position of Fed vice chairman. He is widely viewed as a solid economist, with experience in the financial industry. Trump also plans to nominate Kansas State Bank Commissioner Michelle Bowman as a Fed governor, representing the interests of community banks. Meanwhile, the Federal Reserve Bank of New York recently named John Williams as its next president. He had the same position at the Federal Reserve Bank of San Francisco. The new Fed team is shaping up to be one of pragmatic centrists with few, if any, obvious dissenters.

So far, Chairman Powell hasn’t been fazed by the volatility of the stock market. He and his colleagues could be thrown off course if inflation makes a major comeback. That would force them to raise interest rates faster and higher, which certainly would worsen the outlook for the federal deficit. That would push bond yields much higher and cause serious concerns for stock investors.

The key will be inflation. While Fed officials continue to believe that it is a monetary phenomenon, they may come around to recognize, and even to appreciate, that there are other forces such as global competition and technological innovations keeping a lid on inflation. If so, then the Fed’s current game plan will be realized. (For more on the Fed and inflation, see Chapter 9 in my new book, Predicting the Markets: A Professional Autobiography.)

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