The Fed strikes a hawkish tone

This month’s U.S. Federal Reserve (Fed) statement and press conference went smoothly, notable, since they represented a first from the new Fed Chair, Jerome Powell. Generally, there was no sea change in the message overall, but there was a distinctively more hawkish bent to the tone, reflected in the initial market reaction of declining equity prices and rising U.S. Treasury yields.

The Fed hiked interest rates by 25 basis points (bps), a rise widely predicted; however, the shift in the Federal Open Market Committee (FOMC) dot plot suggests the Fed has become more hawkish than markets had anticipated. We think there are a number of reasons to be skeptical of this hawkishness, and have left our forecast unchanged for three rate hikes in 2018 and two rate hikes in 2019, based on disinflationary forces in the economy, uncertainty about growth in the first half of this year, and tightening financial conditions. 

The median dot suggests the Fed still plans to hike rates three times in 2018, although that’s less of a slam dunk than it was in December 2017. Now, only one more FOMC member needs to think the Fed should hike rates four times this year for the median to shift up, from three to four. Three rate hikes were also forecast for 2019 and a further two for 2020 (both years revised up, by one each, relative to the December forecast). The Fed also increased its expectation for the long-run federal funds rate by roughly 15 bps, to 2.9%. This might not be a huge jump, but we aren’t convinced it should have been moved up at all.

The FOMC also published a series of updated forecasts for the U.S. economy, revealing:

• Slightly higher expected growth rates (2.7% in 2018—right in line with our forecast—and 2.4% in 2019, decelerating to 2.0% in 2020)
• Lower unemployment rates (3.8% in 2018 and 3.6% in 2019–2020)
• Roughly stable inflation rates (hovering around 2.0% for the next three years)

While the Fed expects unemployment to fall over the next few years, it left its estimate of full employment—the nonaccelerating inflation rate of unemployment, or NAIRU—at 4.5%. Taken all together, these numbers simply don’t add up. If you think unemployment will fall almost a full percentage point below NAIRU and still don’t think that will spark an acceleration of inflation, you probably have your estimate of NAIRU wrong. We expect this discrepancy will be revised in June to reflect a lower NAIRU.

Another discrepancy in the forecasts exists between growth and inflation rates. Chair Powell highlighted that the impact of tax cuts on economic growth is uncertain, but he expects any feed through to growth would be demand driven. If this was the case, we should expect growth forecasts to be revised up, with inflation accelerating. The FOMC forecasts reflect higher growth but not accelerating inflation. We disagree with Chair Powell on the impact of tax reform on the U.S. economy; we think the new legislation is a positive supplyside shock and therefore could, if anything, be disinflationary.

We think the FOMC should avoid getting any more hawkish. We aren’t buying the idea that we may be facing a late-cycle surge in inflation. Instead, we expect inflation to accelerate only moderately over the next few years, given a number of disinflationary forces in the economy that, on balance, we expect to offset building inflationary pressures elsewhere.

Longer-term global drivers and disruptors, such as demographics, an oversupply of cheap labor globally, and lackluster productivity growth, will continue to drag on inflation. Additionally, there are three reasons to think the Fed’s dot plots may revert back down, closer to where they were in December:

1. GDP may underwhelm in the first half of this year. The Atlanta Fed GDPNow estimates Q1 GDP at 1.8%, down from over 5.0% at the beginning of the year. Retail sales have fallen three months running, and hours worked, industrial production, and nondurable goods (ex-transport) all fell in January. Industrial production rebounded in February, but the continued fall in retail sales suggests that the result has been a buildup in inventories. Destocking over the next quarter could be a drag on growth.
2. The United States is potentially staring down a trade war with China. We expect the administration to impose tariffs on Chinese electronics and other goods. We also expect China to retaliate with antidumping  cases in agriculture at the World Trade Organization. China may also retaliate in other ways; for example, the People’s Bank of China (PBoC) could rebalance its portfolio away from U.S. Treasury securities. The tariffs the United States has already imposed on steel and aluminum are relatively insignificant for the U.S. economy, but an expansion of tariffs to include other goods and countries—and an inevitable retaliation—would be a drag on growth. It could also boost inflation. Regardless, there’s heightened uncertainty around the economic outlook, stemming from trade.
3. Financial conditions have already tightened this year, even without rate hikes. The spread between LIBOR (the benchmark rate used for adjustable loans, including mortgages) and OIS (the overnight indexed swap, a proxy for the federal funds rate) has risen higher than it has been since 2009. Furthermore, we can expect financial conditions to continue to tighten as the Fed shrinks its balance sheet.

This was Chair Powell’s first press conference—ever. He handled it well, and he seemed to be more of a straight shooter relative to his recent predecessors. This may be owing to his background in the private sector. We can parse his words, but there’s not a huge amount of insight we could glean about the new chair’s personal views on monetary policy. He did suggest that the dot plots should not be taken as gospel and indicated that he’s open to holding a press conference at all Fed meetings so that each one is potentially in play and truly live.