Notes on the Week AheadContributor Dr. David Kelly
One Sword and Three Dragons: What the Fed Should Do Next
“If you can keep your head when all about you are losing theirs and blaming it on you….”
Rudyard Kipling’s first qualification for manhood could equally be applied to the nerve required of the members of the Federal Open Market Committee, who meet this week to decide whether to hike interest rates for a fourth time this year.
In making this decision, they face the handicap of a warrior facing three dragons with one sword. Whether through asset purchases or setting short-term rates, the Fed essentially can only use interest rates as its sword to impact the economy. Meanwhile, the more complicated goals of modern monetary policy are to achieve low and stable inflation while avoiding recession in the short run and warding off asset bubbles, which pose a longer-term threat. It is never easy and it gets harder when commentators and politicians tell the Fed it’s getting it all wrong.
The good news is that the inflation dragon remains relatively well behaved. Last week’s CPI report showed year-over-year inflation of 2.2%, both as a headline rate and excluding food and energy. This week’s numbers on the Consumption Deflator should show something similar, with both the overall rate and the core rate falling to just below the Fed’s 2% year-over-year target.
Wage growth has picked up recently, with average hourly earnings for production and non-supervisory workers rising 3.2% year-over-year in both October and November. However, with GDP per worker likely up by about 1.0% year-over-year in the fourth quarter and high profit margins, it is unlikely that this pace of wage increases, even if sustained into 2019, would lead to a significant rise in consumer inflation. This is particularly the case given a higher U.S. dollar than a year ago, which should restrain imported inflation, and a year-over-year decline in oil prices. There has not been a single reading of core CPI inflation above 3% in since the mid-1990s and the inflation threat in 2019, with or without further Fed tightening, remains minor.
However, the risk from asset bubbles is more significant.
Easy money has generally fueled increases in asset prices in recent decades as financial investments and housing have appeared to be a simpler avenue to wealth than building businesses directly. As testament to this, since 1995, while inflation has remained very tame, the ratio of U.S. assets to U.S. GDP has risen from 4.6 times to 6.8 times. This climb in asset prices has, from time to time, manifested itself in specific bubbles, such as the tech bubble of the late 1990s or the housing bubble of the mid-2000s. Indeed, asset bubbles have been a far greater source of economic disruption over the past 25 years than any broad increase in consumer inflation, and, while the Fed has kept policy tight enough to restrain general inflation, this has not been enough to slow a too-fast increase in asset prices.
The Fed’s third problem, is fighting off recession and, thus far, it has been successful with the U.S. economic expansion likely to enter its eleventh year in 2019. However, with increased stock market volatility and signs of slower growth overseas, there are increasing calls for the Fed to halt its rate increases.
This is where the Fed needs to keep its head first, because current Fed policy is neither too aggressive nor too tight and second, because a change of course at this point could undermine confidence.
The current level of the federal funds rate, at between 2.00% and 2.25%, is essentially equal to core CPI inflation on a year-over-year basis, implying a real, ex-post, federal funds rate of zero. This is lower than the real federal funds rate was 80% of the time in the 50 years before the onset of the financial crisis.
The pace of tightening, at 1% per year, (assuming the Fed does increase the federal funds rate this week), is far slower than the average 2.5% per year pace in the previous five tightening cycles.
Moreover, the U.S. economy looks set to slow rather than stall in 2019. While the unemployment rate is low, it could fall lower still. Meantime, the most cyclical sectors of the economy, including housing, autos and business fixed investment, are all relatively subdued. Reports due out this week on Housing Starts and Durable Goods Orders should confirm this. While some may lament the lack of a bounce in the cyclical sectors, their subdued current levels reduces the risk of the economy sliding into recession because of some economic boom and bust.
It is true that the economy is driven, to some extent, by psychology and if consumers and businesses were to get scared, the economy could slow more in 2019 than we currently anticipate. However, nothing would be more likely to undermine confidence at this stage than a Fed pause, as it would seem like an admission that the Fed itself was scared of recession.
Because of this, in the week ahead, the Federal Reserve should and probably will increase the federal funds rate by 0.25% to a range of 2.25%-2.50%. In doing so, the committee may well nudge down their near-term projections for economic growth and inflation. They may also reduce the number of projected rate hikes for 2019 and 2020 from 4 to 3 or even 2. However, Chair Powell will likely restate his confidence in the economic expansion and the Fed’s intention to prolong it as long as possible. Achieving this goal will require the Fed to keep its head while the stock market continues to manifest its doubts in heightened volatility.