The Federal Reserve is conducting a grand experiment in monetary policy that’s set to continue in tomorrow’s policy statement, which is expected to roll out another hike in interest rates. The experiment is tightening policy when inflation and employment growth are still low and perhaps heading lower.
In previous tightening cycles, pricing pressure and the year-over-year growth trend in private-sector payrolls was higher if not rising. When the Fed raised interest rates during 2004-2006, for example, private payrolls accelerated from roughly an annual rate of 1.5% to 2.4% and the Fed’s preferred measure of inflation (core Personal Consumption Expenditures) increased from 2.0% to 2.5%.
By contrast, core PCE inflation is currently below the Fed’s 2.0% target and ticking lower, dipping to 1.5% for the year through April – the lowest in more than a year.
Private employment growth edged higher in last month’s update, rising to 1.8% vs. the year-earlier level. But it’s unclear if the deceleration trend that’s been unfolding over the last two years has run its course.
The ideal scenario that the Fed seems to projecting: the economy continues to expand at a moderate pace, perhaps picking up a bit of speed, while inflation stabilizes just below or near the 2% target. In that case, the tailwind gives the central bank sufficiently strong macro conditions to continue lifting interest rates, albeit gradually. This outlook is strengthened by recognizing that recession risk remains low these days and economists are expecting that second-quarter GDP growth will rebound. CNBC’s June 9 survey of forecasters shows growth picking up to 2.9% in Q2 from Q1’s weak 1.1% rise.
The question is whether forward momentum is strong enough to overcome tighter policy? Probably, at least for now. Fed funds futures are pricing in a 96% probability that tomorrow’s FOMC statement will unveil a rate hike, based on CME data this morning. When the dust clears, the Fed’s target rate is projected to rise to 25 basis points to a 1.0%-to-1.25% target range.
That’s still a low rate, but some analysts think the central bank is courting trouble by trying to adhere to a 2% inflation target. Last week, 20 economists published an open letter to the Fed that recommends a higher mark.
In years past, a 2 percent inflation target seemed to give ample leverage with which the Fed could lower real interest rates. But given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted.
“The last decade should have shown us that the political system severely controls the tools that policymakers have to fight recessions,” says Josh Bivens, director of research at the Economic Policy Institute and a signatory to the letter. “I see the higher inflation target as one of these buffers.”
The practical effect of lifting the inflation target to, say, 4% would delay monetary tightening, perhaps for several years. Part of the reasoning for such a change is to provide “as much monetary ammunition as possible” going in to the next recession, writes Ady Barkan, a co-director of the Fed Up campaign, an advocacy group that’s pushing for the Fed to adopt a more dovish posture to support growth.
The counterpoint is that the Fed needs to raise interest rates ahead of the next downturn in order to leave room to cut when the next recession strikes. The fear is that the central bank would have much less room for countercyclical monetary policy if the economy’s contracting at a time when the Fed funds rate is unusually low.
Fed Chair Janet Yellen has hinted that keeping interest rates too low for too long could limit the central bank’s ability to act in the next recession. “If inflation were to remain persistently low or the expansion were to falter, the FOMC would be able to provide only a limited amount of additional stimulus through conventional means [at a time of low rates],” she said in a speech last year.
Former Fed Governor Robert Heller has warned that low rates could elevate the risk of a new downturn. “There is a very dangerous scenario building up in the US because the rates are so low and for so long,” he warned a year ago.
Fast forward 12 months and there’s still no sign of recession, based on current data. But it’s debatable if the economy is strong enough to warrant more rate hikes and a general tightening of monetary conditions. Real (inflation-adjusted) base money supply (M0) has been contracting for well over a year – a sign that the Fed’s hawkish bias remains intact. That alone probably doesn’t raise recession risk, but it’s one more risk factor.
For now, the Fed can still point to enough sources of growth to argue that raising rates is still prudent. But keep an eye on tomorrow’s monthly update on consumer price inflation, which will be released ahead of the FOMC statement.
The consensus forecast sees headline inflation ticking down to an annual 2.0% rate in May from 2.2% previously, according to Econoday.com. Core inflation is projected to hold steady at a slightly softer rate of 1.9%. That’s probably high enough to give the Fed cover for another round of rate hikes.
A weaker-than-expected inflation rate, however, could change the calculus and support complaints in some circles that the central bank’s monetary stance is too hawkish in the current environment. What are the odds that CPI will undershoot expectations? A new survey of inflation expectations in May suggests it’s not a zero probability.
“Median one-year ahead inflation expectations decreased from 2.8% in April to 2.6%,” the New York Fed reported. “Median three-year ahead inflation expectations dropped from 2.9% in April to 2.5%, their lowest reading since January 2016.”
That’s hardly a warning sign per se, but it’s a reminder that pricing pressures may be softening… again. If so, the case for raising interest rates tomorrow may not be as sturdy as previously assumed.