Powell Faces a Delicate Balance in Testimony to Congress

(Bloomberg Opinion) -- The higher U.S. inflation numbers released Thursday will add weight to the Federal Reserve's policy deliberations when the Open Market Committee meets on July 31 and Aug. 1. The price data, along with continued signs of a solid domestic economy, would encourage Fed officials to signal a rate hike at the following FOMC meeting, in September, and leave open the possibility of a fourth increase this year. Yet central bankers will need to also take into account the risks to business investment from rising trade tensions at a time of more fragile global economic momentum.

The old Fed, led by Chair Janet Yellen, would have erred on the side of caution and postponed the next interest rate hike until December. The outlook is less clear under the leadership of the new chairman, Jerome Powell. This uncertainty also makes Powell's congressional testimony next week even more worthy of attention.

At 2.9 percent for the 12 months through June, headline inflation is now its highest since early 2012. The core measure, which excludes more volatile items such as oil, came in at 2.3 percent, the highest since the start of 2017. And data released earlier in the week showed that the producer price index rose 3.4 percent year on year, suggesting there is more inflation in the pipeline.

These increases will bolster confidence within the world’s most powerful central bank that its own preferred measure of inflation, the personal consumption expenditure price index, is likely to settle around its 2 percent target. Together with the major progress in the labor market that was highlighted again by the jobs report for June, this implies that the Fed is very close to meeting its dual objectives. The numbers are also consistent with Powell's assessment this week that the U.S. economy is in “ a good place” and that the recent tax cuts will provide at least three years of growth stimulus.

But Fed officials need to consider the concerns of companies that are said to be thinking about scaling back or postponing business investment plans due to uncertainties about trade policy. The topic was featured in the minutes of the European Central Bank released Thursday and in the Fed minutes last week. These worries are arising as several economies outside the U.S. risk losing some of their growth momentum and China faces higher financial volatility. Also, notwithstanding valid offsetting technical considerations, the Fed is unable to totally dismiss the notably flat yield curve reflected in a 26 basis-point differential between two- and 10-year Treasuries and a 36 basis-point spread between two-year and 30-year bonds. Such numbers have historically signaled a high probability of a domestic economic slowdown.

The old Fed would have seen this second set of considerations as a reason to refrain from sending strong signals about a September rate hike at the next FOMC meeting. There isn't yet a sufficiently long track record to determine with confidence how the new Fed would be inclined, particularly when policy considerations are so finely balanced. We may know a little more when Powell meets with lawmakers next week.

The little evidence we have suggests this may be a relatively more hawkish policy-making context than previously, and not only because of the words, actions and projections that have come out of the FOMC meetings. Unlike on previous occasions, Fed officials this year have notably refrained from making comments aimed at repressing financial volatility during the periods of global market instability between meetings. With that, the markets' confidence in the “central bank put” has decreased.

Where does this leave me in terms of Fed policy expectations before the important semi-annual congressional testimony on monetary policy on July 17 and 18? At least for now, I'm sticking to a baseline of a total of three hikes for 2018. I also think that it’s finely balanced whether the next increase will be in September or December, and that the overall balance of risks is now tilting further in favor of four hikes.

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