Powell's Fed Policy Gambit Bets Jobs Stay Hot, Inflation Not
(Bloomberg) -- Federal Reserve officials are sounding increasingly confident they can run the U.S. economy hot without a harmful rise of inflation, a risky gamble for Chairman Jerome Powell with unemployment low, price pressures edging higher and fiscal stimulus about to goose growth.
An improving inflation outlook has helped advance 10-year U.S. Treasury yields to a four-year high above 3 percent, pushing the dollar to its strongest levels in three months. Yet policy makers are expected to leave interest rates on hold at their meeting next week and signal no change to the gradual tightening path they’ve penciled in for two or three more 2018 hikes.
Their caution, shaped by the post-crisis years in which they struggled to lift inflation, is a departure from the preemptive strategies of U.S. central bankers in past business cycles to stay abreast of the economy’s turns. That contrast has not escaped the attention of Fed officials, who remember the lessons of history.
“Sometimes I wonder if I risk having my Ph.D. revoked for being seduced into amnesia about the Great Inflation of the 1970s,” Chicago Fed President Charles Evans said on Friday. “We have the opportunity to more patiently read -- and react to -- the incoming data.”
It’s not just the doves who sound relaxed. Loretta Mester, the more hawkish head of the Fed Cleveland, said last week that she doesn’t expect inflation to pick up sharply and “this argues against a steep path” of rate hikes. John Williams, the San Francisco Fed president who shifts in June to run the New York Fed, said he doesn’t “see signs of anything I look at, or others do, of inflationary pressures really building.”
The Fed’s laissez faire response is an experiment that carries big risks and rewards. The central bank forecasts keeping rates at a stimulative setting -- below the so-called neutral level that neither supports nor hinders growth -- until the end of next year. Only in 2020 do they project a policy stance that would be tight, with rates seen at 3.4 percent by year-end compared with a neutral estimate of 2.9 percent.
Adding momentum this year are $1.5 trillion in tax cuts and $300 billion in new federal spending. President Donald Trump argues that the tax overhaul combined with deregulation will help the economy accelerate at a time when the labor market is already stretched.
Fed officials are “taking a risk, or rather it has been taken for them because of badly timed fiscal stimulus,” said former Fed Governor Laurence Meyer, who runs a policy research firm in Washington. “They can’t prevent an overshoot, so the question is can they contain it without causing a recession?”
Such an outcome would be “an immaculate soft landing,” he says, where they tighten just enough to curb inflation but without causing severe damage to growth and employment.
U.S. central bankers are aware of the gamble, and say they have good reasons for making it. Minutes of their policy meeting in March show them discussing how a strong economy could help them achieve their 2 percent inflation target -- a goal they have missed for most of the past six years.
Indeed, there is a campaign underway at the Fed to soften the idea that the target is a hard ceiling. Their March forecast shows a small breach of 2 percent in 2019 and 2020 in core inflation, which strips out energy and food prices. New York Fed President William Dudley told CNBC television April 16 that gradual hikes are fine so long as inflation doesn’t go above 2 percent by “an appreciable margin.”
Risk management is driving the strategy. Fed officials want to go into the next recession with an inflation buffer. That will help keep rates above zero as they ease policy to support growth, and help anchor inflation expectations at higher levels to avoid any risk of deflation, which is harmful to an economy.
The Powell Fed is also continuing former Fed Chair Janet Yellen’s labor experiment. Unemployment has held at 4.1 percent for six straight months despite adding 1.3 million new jobs as people renter the workforce. That’s good news. At the same time, there’s no evidence of wages or inflation suddenly sprinting ahead.
With so many upside gains, what could possibly go wrong? The risk is that the relationship between unemployment and inflation -- which now looks “broken or flat” -- suddenly isn’t, said Michael Hanson, chief U.S. macro strategist at TD Securities in New York. A blowout into overheated growth could force the Fed to tighten more aggressively, triggering a recession.
“We have to be vigilant to make sure we’re not overstimulating the economy and generating either wage and price increases that are faster than what we’re going to want in the long run, or financial stability concerns,” Boston Fed President Eric Rosengren, a former dove who has become a leading siren on too-low rates, said in an interview April 13.
At some point, Fed officials may have to signal that the inflation overshoot has gone on long enough and they will quicken the pace of tightening. That would be a regime change, and even if it’s not as aggressive as Chairman Alan Greenspan’s 1994 hiking campaign, when rates were doubled to 6 percent over 12 months, it could still spell disruption.
“The history of the Fed isn’t’ very successful at this,” said Ethan Harris, head of global economics research at Bank of America in New York. “Is this going to be hard to pull off? Absolutely. Is it worth trying? Yes.”
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