Fed’s Gradualism Will Gradually Change
Recent fedspeak has featured the word “gradual” to describe the Fed’s approach to monetary tightening. In his speech at Jackson Hole, Wyoming on August 24, Fed Chairman Jerome Powell described the two key risks of raising interest rates in an expanding economy; (1) moving too fast and shortening the expansion, and (2) moving too slow and letting inflation get out of control. Powell said, “I see the current path of gradually raising interest rates as the FOMC’s approach to taking seriously both of those risks.” Dallas Fed President Rob Kaplan wrote in his essay from August 21, “..we should be removing accommodation (by raising rates) in a gradual manner to get to a neutral policy stance.”
So far in 2018, gradualism has meant a 25 basis point increase in the fed funds rate range every other meeting, beginning in March. After the March rate hike came the June rate hike. We expect that cadence to continue on September 26, and again on December 19 for a total of four rate hikes in 2018 over a period of eight FOMC meetings.
In looking ahead to 2019, we encounter the problem with gradualism. The problem with gradualism is that it is only a description of the pace of rate hikes. It is not a justification for rate hikes, and it offers little guidance about what will happen when conditions inevitably change. Moreover, even as Powell and the rest of the Federal Open Market Committee seek to define what they are doing, the conditions that justify gradualism are already changing.
As economist Herb Stein said succinctly, “If something can’t go on forever, it will stop.” What Stein’s Law intuited is that the U.S. economy does not run at steady state. A quick review of historical GDP growth shows expansions and recessions. Even in long expansions, quarters of faster growth are followed by quarters of slower growth. The U.S. economy accelerates and decelerates. It does not run at a steady state.
We are concerned that after the current period of acceleration, featuring 4.2 percent real GDP growth in 2018Q2, the U.S. economy will decelerate sometime in 2019, and the Fed’s gradualism will have to be redefined.
Strong job growth has fueled the economy’s recent acceleration. The U.S. economy has created an average of 207,000 net new payroll jobs per month this year, through August. It is unlikely that that pace of job growth can be sustained into 2019. This year we see that there are currently more job openings than there are unemployed workers. This is the first time that has happened since the Job Openings and Labor Turnover Survey was initiated in 2000.
With available labor becoming scarce and capacity utilization running high, businesses will have to spend more on capital in order to keep expanding production. This would lift productivity growth and help alleviate the inflationary pressure from increasing wages. We saw some pickup in the rate of business investment early this year after the corporate tax law was changed. However, we have not seen a sustained industry-wide acceleration in bank lending to fund capital expansion. Rather, we are concerned that both labor and capital may eventually constrain the economy, particularly as capital becomes more expensive after two more fed funds rate hikes this year. This could be similar to what is happening in the housing market now as the limited availability of houses for sale, and their decreasing affordability appears to be keeping the market in check despite pent-up demand. Slower rest-of-world growth and U.S. fiscal contraction are also downside risks for late 2019 and early 2020.
We expect the Federal Reserve to slow the every-other-meeting pace of rate hikes next year. The adoption of a press conference after every FOMC meeting will give Powell more flexibility to change the cadence of rate hikes as the Fed approaches the peak fed funds rate for this cycle by the end of 2019 or early 2020.
For a PDF version of this report, please click here: September 2018 U.S. Economic Outlook
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