Fed starting to plan for a waning of Trump's pro-growth sugar high

Fed starting to plan for a waning of Trump's pro-growth sugar high
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With the September Federal Open Markets Committee (FOMC) meeting rapidly approaching, the attitude of some Federal Reserve officials has begun to shift to a slightly more accommodative or certainly less aggressive tone.

Even St. Louis Federal Reserve President James Bullard, who recently applauded the Trump administration’s efforts in spurring growth, appears to be in favor of the Fed taking pause at year-end.

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With a lack of meaningful gains in wage growth, a rising risk of yield curve inversion and little worry of an overheating economy as momentum is expected to wane, some Fed officials seem to be shifting from their perpetual “gradual” stance, calling into question the possibility of a fourth-round rate increase at the end of the year.

In less than 11 days, the FOMC is scheduled to meet for the sixth time this year. And, at the Sep. 26 meeting, the Fed is widely expected to raise rates for the third time this year to a range of 2.00-2.25 percent.

Beyond this month’s decision, however, the pathway for rates is becoming increasingly murky as the Fed struggles to find neutral policy with some suggesting current policy is already somewhat restrictive.

In other words, while a September rate hike is seen as a sure thing, further rate action this year and beyond is being called into question with the Fed potentially slowing the pace of adjustments.

Finding neutral

Fed members continue to anticipate a longer-run fed funds rate near 3 percent. However, with the 10-year yield averaging 2.89 percent over the past three months, the Fed’s presumed “neutral” level could potentially distort the curve to the point of inversion.

While not a perfect one-for-one correlation, as the short end of the yield curve follows along with a presumed quarter-point increase at the upcoming FOMC meeting, without an equal rise on the longer end, the differential between short-term and long-term rates could be reduced to next to nothing by month-end.

Such a minimal differential would leave the curve vulnerable to inversion sooner than later. And of course, an inverted curve has historically preceded every economic recession in post-World War II history, a phenomenon which has not been overlooked by the Fed.

Federal Reserve Chairman Jerome Powell is among those who remain skeptical that a curve inversion implies a lurking recession around the corner. Despite being a reliable predictor in the past, Chairman Powell has noted little concern regarding the possibility of an inverted curve.

In previous comments, the Fed chief explained that such an anomaly is more likely a reflection that policy is closer to a neutral level than previous forecasts indicate. Furthermore, given the unprecedented level of monetary policy intervention in the recent past, Powell has warned the yield curve is no longer the predictive measure it once was.

But while the chairman seems undeterred by the risk of an inverted yield curve, other committee members have issued a higher level of concern, warning a curve inversion simply increases the vulnerability of the economy to recession despite the Trump administration’s pro-growth policies.

Bullard, for example, acknowledged the relative strong growth in the U.S. economy thanks in part to a reduction in corporate taxes and improvement in business sentiment. However, an inverted yield curve, he worries, would exacerbate the likelihood of recession over the coming year(s) regardless of temporary stimulus from fiscal policies.

At this point, the majority of Fed officials see the economy losing significant momentum over the coming 24 months as the boost from the tax-cut wears off. Potentially maintaining an above trend pace for the remainder of 2018, growth is expected to slow to 1.75 percent over the longer-run.

Going forward 

The majority of Fed officials are not in favor of an immediate pause in rate hikes. Although, even some of the more hawkish members voicing earlier concerns of the economy overheating, an acceleration some have attributed to action in Washington, have adopted a more patient tone.

In other words, the sense of immediacy previously noted has dissipated for even those previously in favor of an above-consensus path for rates to push beyond neutral. Furthermore, it has diminished the appetite for tightening all the way to 3.5 percent.

Some Fed members still contend the economy can withstand two-or-more increases this year. Seemingly more, however, are beginning to noticeably temper expectations for growth and inflation beyond a short-term lift from a pro-growth agenda, questioning the need for preemptive monetary action.

Still, some worry the current pace of hikes is already overly aggressive and will force the economy into recession, with a still modest level of inflation and rapidly rising risk of an inverted yield curve. At this junction, the tone of the Fed has begun to morph from one of urgency to remove accommodation to one of wait and see. 

A September rate hike is fully priced into the market. By December, however, the Fed appears poised to take a more patient approach to rates. In other words, an end-of-the-year rate hike appears increasingly questionable as the voices of the skeptics on the Fed grow amid international uncertainty and less than impressive wage growth. 

We continue to anticipate a rate hike at the next meeting, but the Fed is likely to go into pause mode sooner than later with leaders in Washington having little say in the matter. If not by December, the chairman himself is likely to advocate for a more patient pathway as we turn the page into next year.

Lindsey Piegza is the chief economist for Stifel Fixed Income. Her research has been published in the Harvard Business Review and in textbooks for Northwestern University's Kellogg Graduate School of Management. She's a regular guest on CNBC, Bloomberg, Fox News and CNN.