The Federal Reserve has checked all of the boxes. Inflation, unemployment and even wages are moving in the right direction. Ultra-easy monetary policy is no longer necessary. Rate hikes are an affirmation of a long journey for the economy back from the financial crisis to what the Fed considers full employment and stable price levels.
The governors appear to be shifting to worrying about imbalances (bubbles) and the risk of overheating. The debate at the September meeting will be intense (as we will see later in the minutes) on what the neutral rate actually is. Governor Lael Brainard, who is a powerful voice on the board, appears to have shifted her view recently, arguing that the stronger economy justifies a higher neutral rate. This suggests a Fed that is chasing rates up instead of down.
The risk is that the Fed could overshoot on the upside; some are clearly concerned that they may have overshot to the downside. This is the hard reality: The Fed is almost always behind the curve in dealing with the economy because of lags in the data and justifiable uncertainty regarding their own models. Members of the Federal Open Market Committee (FOMC) are reacting now to an economy that is performing better than they expected, which justifies further increases in short-term interest rates. Potential problem: Rate hikes could go on for longer or be less gradual than financial markets currently anticipate.
Another challenge for the FOMC is that simple economic models show the drag from tariffs is very small. Models, however, cannot capture the uncertainty on the ground or the shifts in the complexity of supply chains over time. Some producers have applied to the administration for waivers from the initial effects of tariffs on China because the country is literally their only source for specific inputs. Other producers are counting on weakness in the Chinese currency to blunt the effects of higher import costs.
The regional Federal Reserve bank presidents are not as confident on this. They are nearer to the front lines of escalating trade tensions. Look for Fed Chairman Jay Powell to acknowledge trade risks in his comments following the meeting on Wednesday. There may be a push by others to include trade risks in the statement, but I wouldn’t bet on that. The Fed has been a political piñata since the onset of the financial crisis. Nothing would be gained by getting too far ahead of the actual effects of tariffs.
Our forecast holds for two more rate hikes in 2018, in September and December, marking four hikes this year. We expect the pace to slow in 2019 with two rate hikes for the year.
Copyright © 2018 Diane Swonk – All rights reserved. The information provided herein is believed to be obtained from sources deemed to be accurate, timely and reliable. However, no assurance is given in that respect. The reader should not rely on this information in making economic, financial, investment or any other decisions. This communication does not constitute an offer or solicitation, or solicitation of any offer to buy or sell any security, investment or other product. Likewise, this communication serves to provide certain opinions on current market conditions, economic policy or trends and is not a recommendation to engage in, or refrain from engaging, in a particular course of action.