Memo to Powell: Best not to offer hostages to fortune

Memo to Powell: Best not to offer hostages to fortune
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I’d be astonished if the outcome of the Federal Open Markets Committee meeting is anything other than a 25-basis-point rate hike.

Chairman Jerome Powell has had ample opportunity, if he so wished, to nudge markets away from the idea that rates will rise today, but instead, his recent congressional testimony endorsed the idea of continued “gradual” tightening, set in motion by former Chairwoman Janet YellenJanet Louise YellenTrump puts hopes for Fed revolution on unconventional candidate Fed chief basks in bipartisan praise as lawmakers dismiss Trump attacks New bill will get the labor market running on all cylinders MORE.

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Most of his colleagues, including the previously unimpeachably dovish Lael Brainard, also have sounded ready to act again. Markets put the odds of a hike today at about 95 percent; that looks about right.

 

After a widely-anticipated central bank policy move, what really matters is what policymakers say about their actions and intentions. In the Fed’s case, intent is conveyed in three ways at the end-quarter meetings, with the post-meeting statement, the updated Statement of Economic Projections and the chairman’s press conference all influencing market thinking. 

Wednesday's press conference will be Chair Powell’s first, so I can’t be sure how he will play the event compared to his predecessors. But I’d expect him to emphasize continuity of approach and the collective nature of Fed decisions — he’s the chair, not a dictator — so it would be surprising if he said much, if anything, beyond what’s in the documents. 

Reporters, however, will be very keen to try to see if Powell can be persuaded to acknowledge that the recent tax cuts and increases in government spending have increased the risk of the economy overheating. But the Fed chairman is a lawyer, and he knows how to respond to a potentially awkward question without actually answering it.  

Still, he is bound to be faced with questions along the lines of, "Why are you not raising your interest rate forecasts in the wake of the substantial, unfunded fiscal easing?”

His reply, I suspect, will be something like:

"It’s not our job to tell Congress how to conduct fiscal policy, and it’s too soon to assess the impact of the tax cuts and spending increases.

"Much of the easing of policy could be saved rather than spent, and there are encouraging signs that productivity is picking up, so any upturn in wage growth as a result of fiscal loosening need not necessarily generate higher inflation. 

"In any event, with inflation well below target, gradual normalization is the best way to balance the risks of both future inflation and the premature ending of the cycle via excessive tightening." 

No matter how hard the media push him, Chair Powell is not going to say that the fiscal easing is a mistake.

Nonetheless, the FOMC’s new projections likely will show faster growth this year and next than was expected in the December forecast round. Some FOMC members made explicit allowance for the tax cuts in their December forecasts but the spending bill came as a surprise in early February, so it will have to be folded into the numbers. 

Other things remaining equal, forecasts of stronger growth ought to be accompanied by even lower projections for the unemployment rate and higher inflation, and/or higher interest rates.

But policymakers can easily choose not to head down that path simply by assuming a stronger cyclical pick-up in productivity growth and rising labor participation. They could be wrong, but these data are so erratic and unreliable that just about anything can happen in the near-term.

I’m not willing to assume that productivity and participation will rise by enough fully to offset the impact of stronger growth, thereby freezing the unemployment rate at its current level, but it’s not a crazy idea.

I’m pretty sure that the Fed’s new forecasts won’t show one-for-one shifts down in the unemployment forecasts alongside faster GDP growth, and I doubt the inflation forecasts will move up materially. That means the Fed will be able to stick to its forecasts for a total of three increases in rates this year.

The lessons of 2015 and 2016, when the Fed forecast a total of eight rate hike but eventually acted just twice, is that it’s best not to offer unnecessary hostages to fortune. And right now, with inflation well below target and wage gains modest and steady, Powell and his colleagues can make a persuasive case that their current plans are sufficient.

That story will be less plausible later by the fall. But for now, policymakers will cross their fingers behind their backs and hope that this year really will see a clear increase in both productivity and labor participation, with inflation staying low.

If everything goes well, they might be right. In the meantime, investors today will be relieved that the improving growth story hasn’t triggered a serious upsurge in inflation risk. Yet.

Ian Shepherdson is the chief economist and founder of Pantheon Macroeconomics, a provider of economic research to financial market professionals. Shepherdson is a two-time winner (2003, 2014) of the Wall Street Journal's annual U.S. economic forecasting competition.