Fed Concerned by Weak Underlying Demand

The Federal Open Market Committee (FOMC) is scheduled to conclude its third major policy meeting of the year on May 1. The upside surprise on real GDP growth in the first quarter does not provide any assurances. Over half of the gains were due to bloated inventories and a slowdown in trade. Underlying consumer spending, business investment and government spending weakened, while housing construction contracted for the fifth consecutive quarter.

Some of that weakness is transitory. During the second quarter, consumers started to spend more aggressively in the wake of the polar vortex; this will help to drain unwanted inventories but at a price. Discounts are likely to remain high as more retailers shut their doors.

The silver lining is employment, which has improved since the FOMC met in March. Average hourly earnings rose at a 3.2% pace from a year ago in March, slightly slower than the 3.4% in February but still above the Fed’s implicit goal of at least 3% wage growth. The disappointment remains inflation, which is still more tepid than the Fed would like to see, given how far we are into this economic expansion. Core PCE slipped to 1.6% in March, nearly one half percent below the Fed’s current 2% target. That is a level that some within the Fed have argued, if sustained, would require a cut in rates. The Fed is looking to refine its decision rule and communication of its inflation target in 2019.

The FOMC is expected to keep the “patient” stance on rate hikes, consistent with the March statement. We also expect to hold to the stance that the inflation target remains “symmetric” at 2%. That means that they would tolerate a little overshooting of the 2% target before actually raising rates. The Fed is working on clarifying how to best communicate its goals on inflation and employment and will move to clarify what it actually means when it says the 2% target is symmetric: Does it means the Fed will tolerate 2.25% inflation for a long period? Or something much higher? The Fed could even change its target entirely over the course of the year.

Separately, the Fed is reassessing what its optimal balance sheet would look like. The Fed announced a halt to shrinking the balance sheet by October of this year with a preference to hold Treasuries over mortgage-backed securities. It is unclear what the maturities of those Treasuries will be when all is said and done.

Chairman Jay Powell is expected to keep his remarks short next week. Less is more, given the criticism the Federal Reserve has faced from the administration. The Fed did not cause the slowdown in growth alone. Indeed, much of the havoc we saw in financial markets in December may be traced to the administration’s own threats of a full-blown trade war with China. That doesn’t mean the administration won’t continue to openly blame the Fed. The best that Powell can do is to stay the course and keep his noise-cancelling headphones charged to focus on where we are economically, not politically.

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