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The future of Fed policy looks strong

The future of Fed policy looks strong
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The Federal Reserve meets one more time this year and is expected to deliver the third rate increase of 2017, taking the federal funds rate target range to 1.25 percent to 1.5 percent. It will be followed by Fed Chairman Janet Yellen’s last post-meeting press conference. While doubts linger on the Federal Open Markets Committee over the persistence of subdued inflation, this did not seem a concern for this year, as October’s meeting minutes stated that “many” expected a tightening in the “near term.” With markets pricing a 90 percent chance of a hike and no official communication to the contrary, the chances of a move appear high.

More interesting will be the path of policy thereafter. I forecast a more upbeat United States in 2018 than the FOMC’s September projections. Namely, I forecast gross domestic product growth accelerating to 2.5 percent next year. Expect unwinding base effects from 2017 to lift “core” personal consumption expenditures inflation. I consider cyclical inflation developments, particularly accelerating wages, to be more prominent. Fed projections may begin to capture some of this as it incorporates the prospect of tax reform in its forecasts, perhaps as early as the December projections. This outlook should underpin the Fed’s case for continued policy tightening.

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The pace of official tightening will depend on developments in broader financial conditions. This has been apparent in recent years. For example, a slower than envisaged pace of tightening in 2015 and 2016 in part reflected the sharp appreciation of the U.S. dollar. A quickening this year, including the start of a balance sheet unwind, has coincided with dollar reversal, alongside improving risk appetite and broadly stable government bond yields.

To my mind, markets currently underprice the risks of Fed policy tightening over the coming years. A shift in these expectations could result in tighter financial conditions, in turn reducing the need for official policy tightening. However, net global quantitative easing will continue to rise in 2018, despite the Fed’s balance sheet reversal, continuing positive spillovers into U.S. financial conditions. Moreover, any dollar appreciation in 2018 would have to overcome likely further euro gains, potential recovery in the Mexican peso, and a broader “risk-on” tone.

I forecast the Fed raising the federal funds rate target three times across 2018, closing next year at 2 percent to 2.25 percent, assuming a modest dollar appreciation. We expect three further hikes in 2019 to 2.75 percent to 3 percent. However, if financial conditions follow the “usual” lagged response to policy tightening, 2018 could still see relatively easy conditions and could prompt the Fed to move quicker.

Overseeing these decisions will be a new leadership team, under Fed Chairman Jerome Powell, whose history does not suggest a sharp shift in policy approach. New members might alter that balance, particularly if they are selected along traditional Republican, hard money values. However, the Fed’s outlook already follows a Phillips Curve and Taylor Rule approach, and the evidence of this year suggests any easy money bias on the Fed is more one of perception than reality. We do not expect the change of personnel to affect the Fed’s reaction function.

More important could be the growing discussion surrounding a review of the Fed’s monetary policy framework. The scope of any such discussion will be defined by the new chairman and governors. This might include details on communication, including whether to publish a quarterly report, or to reconsider the number of post-meeting press conferences. Yet, some Fed presidents have suggested a review of the Fed’s inflation target. While the Fed only adopted a 2 percent target in 2012, evidence of recent years question whether this is still optimal.

A lower neutral rate suggests the scale of future conventional policy easing the Fed can bring will again be constrained by the zero lower bound. Adjusting the inflation target could alleviate this constraint. Price level targeting, as mentioned in the recent minutes, would be a more formal commitment to forward guidance. The Fed could even raise its inflation target from 2 percent. So long as markets believed this credible it would increase the nominal long-term interest rate.

This year has proven benign for markets with solid growth, subdued inflation, and gradual monetary policy tightening. Faster growth in 2018 is unlikely to be met with the same subdued inflation and could result in hardened resolve at the Fed. Moreover, this point in the cycle and the change in leadership provides an opportunity for a more fundamental adjustment to bolster the Fed’s arsenal for the future.

David Page is senior economist at AXA Investment Managers.