A reconstituted Federal Reserve under new leadership will face tough challenges in the year ahead. Monetary normalization is well underway, with the Federal Open Market Committee (FOMC) having raised the Federal funds rate five times since it left the zero lower bound two years ago and started shrinking the bloated balance sheet built up through three rounds of bond buying.
By most standards, former Fed Chair Janet Yellen’s policies were a success. The unemployment rate has fallen to a 17-year low of 4.1% and it appears headed lower yet with the economy growing at a 3% pace. The financial system seems to be on a sound footing with no obvious imbalances.
The Fed’s only shortcoming — at least as far as officials like Chicago Federal Reserve Bank President Charles Evans are concerned — is that inflation has persistently undershot the Fed’s 2% target. But arguably this is a good problem to have, and if the policymaking FOMC majority is correct, it won’t be with us too much longer.
Into this favorable mix comes a big injection of fiscal stimulus.
Conventional (Keynesian) wisdom would have us believe the $1.5 trillion tax cut package comes at the wrong time: when the economy doesn’t need stimulus. Furthermore, it is argued, tax cuts will force the Fed to do more monetary tightening and perhaps put the economy in jeopardy of a recession. Well, maybe, but there’s another way of looking at it. The tax reforms are not designed just to spur aggregate demand, thus straining resources—not that that that would be an immediate problem in a climate of modest wage-price pressures.
There are also crucial “supply-side” aspects of the tax law that stand to boost business investment, capital formation and productivity. If they work as designed, lower corporate tax rates, expensing and incentives to repatriate overseas profits will boost the economy’s capacity to grow without accelerating inflation.
Fed policymakers may have to reassess some of the assumptions they’ve been making. Last year, a consensus developed that the longer run “neutral” funds rate had fallen and was destined to stay lower than normal (though not as low as currently). In September the FOMC slashed the neutral rate 10 basis points to 2.8%, making a cumulative 145 basis point reduction since early 2012 (see “What is normal?” left). This was all because of a putative drop in the “real” interest component (r*), which has been steadily downgraded along with the economy’s perceived growth potential due to slower growth of productivity and the labor force.
Simultaneously, suspicions grew among officials that below-target inflation might be more lasting than previously thought. This thinking reinforced the FOMC’s gradualist inclinations, despite plunging unemployment.
But what if the economy has shifted into a higher gear with different monetary parameters?
So far, FOMC participants are reluctant to make that assumption. In December, they elevated their GDP growth projections, though not a great deal, to 2.5%, while lowering their unemployment rate projection to 3.9%. Yet, they kept their median funds rate projections for 2018 and 2019 — three rate hikes this year to 2.1%; two next year to 2.7%. Not until 2020 do they envision a modestly faster pace of rate hikes with the funds rate projected to reach 3.1% instead of the 2.9% foreseen in September (see “Midstream corrections,” below).
Explaining why the FOMC did not accelerate funds projections, given faster growth forecasts, in her final press conference, Yellen said, “Growth is a little stronger. The unemployment rate runs a little bit lower, that would perhaps push in the direction of slightly tighter monetary policy, but ... counterbalancing that is that inflation has run lower than we expect, and... it could take a longer period of a very strong labor market in order to achieve the inflation objective.”
The Fed’s test will be discerning whether faster growth and greater resource utilization require more aggressive tightening or whether the promise of improved productivity, better GDP potential and perhaps a lower full employment rate warrant forbearance. The FOMC may have to balance the two sets of considerations, raising rates more than projected in December, but not as much as some might recommend.
With stock values “elevated,” as Yellen delicately put it, the FOMC will also have to factor in asset prices into its policy judgments.
Another mounting concern coming into the New Year, at least for some, is a flattening yield curve and the prospect of an inverted one. But the predominant view at the Fed is that such concerns are vastly overrated.
Yellen acknowledged, “A strong correlation historically between yield curve inversions and recessions,” but added, “correlation is not causation, and there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.”
She noted the term premium, historically positive, is “quite low,” which means “the yield curve is likely to be flatter than it’s been in the past. And so it could more easily invert if the Fed were to even move to a slightly restrictive policy stance.”
Against this somewhat perplexing backdrop the FOMC is undergoing wholesale changes in make-up — not just a new chairman but, relatively soon a new vice chairman and a New York Fed president (the FOMC vice chairman), among other changes.
Governor Jerome Powell, who becomes Chairman in February, has committed to continuing Yellen’s gradual normalization. But given all the changes, we can’t assume the past will be prologue. Monetary policy is likely to depend less on personnel than on how a resurgently dynamic U.S. economy unfolds.