The Fed Knows Better Than to Be Fooled by 'Soft' Data
Federal Reserve officials continue to anticipate additional monetary policy tightening this year on the order of another two interest-rate increases. They have no reason to back down just yet. The weakness seen in “hard” economic data based on actual performance relative to “soft” data, such as surveys, is enough to temper concerns that they are falling behind the curve and keeps a May move off the table. That means they can be patient and adjust their forecasts, if necessary, before the June 14 meeting.
On the dovish side, Chicago Federal Reserve President Charles Evans could support another two rate hikes if the forecast firms, but really maybe only one more. Similarly, St. Louis Federal Reserve President James Bullard is not pushing for an additional hike. On the more hawkish side, Boston Federal Reserve President Eric Rosengren argued for four increases, while San Francisco Federal Reserve President John Williams does not rule out such a scenario.
New York Federal Reserve President William Dudley, who has his finger on the pulse of the central tendency of the Federal Open Market Committee, sees the case for three rate hikes this year and action on the balance sheet. More interestingly, he explicitly states that reducing the size of the Fed's balance sheet assets could even be a substitute for a rate increase.
Following that logic, and assuming the economy holds its ground this year, the Fed will push up rates another 50 basis points and then shift gears to shrinking the balance sheet by phasing out the reinvestment of maturing securities. Getting to four rate hikes and balance sheet reduction likely requires clear evidence that both the economy is poised to overheat and that financial conditions are not tightening sufficiently in response to monetary policy action.
But is this just putting the cart before the horse? Getting a read on the economy is complicated due to the divergence between soft survey measures and hard data. The former surged in the wake of the election, while the latter remained lackluster. For example, the February report on the consumer revealed a meager 0.1 percentage gain in spending, seemingly at odds with strong consumer confidence numbers:
On the other hand, some “soft” data is arguably fairly hard. The ISM manufacturing report was again solid in March and appears consistent with a rebound in hard data for that sector:
Putting it all together, the Atlanta Federal Reserve currently anticipates a disappointing 1.2 percent gain in first-quarter annualized economic growth. That's not exactly the kind of data you would think the Fed would be using to justify further rate hikes.
But it should not come as a surprise that the Fed would be looking through these weak numbers. They recognize that residual seasonality issues -- the tendency for first-quarter growth to be unusually low -- may be holding down estimates. Policy makers also know that net exports and inventories account for much of the weakness. The Fed will thus seek guidance from real private final sales, which the Atlanta Fed currently estimates growing at a 2.6 percent pace. Hence, the underlying economy looks to be growing at a rate that might exceed their forecasts. Also, the soft data represent upside risks to their forecasts.
The employment numbers are likely more important than the GDP tracking estimates at this juncture. Ongoing solid job growth –- the economy has been averaging 209,000 for the last three months -- will ease worries over first-quarter growth estimates. An additional drop in unemployment or faster wage growth would raise concerns that the economy is closer to overheating than policy makers believe.
Moreover, the Fed always has a wary eye on inflation. Coming in at 2.1 percent over the past 12 months, topline personal consumption expenditures finally pierced the Fed’s 2 percent target for the first time since 2012. Even if inflation stalls, the Fed will also be looking through those numbers to gauge underlying trends. Note that core inflation started the year with two solid monthly gains. The January number, however, received an unusual boost from durable goods inflation that faded in February. Although similar gains at the beginning of 2016 faded, if the numbers continue like the first two months, the Fed will grow concerned they are falling behind the inflation curve.
And don’t forget inflation expectations. In his explanation of why he dissented at the March FOMC meeting, Minneapolis Federal Reserve President Neel Kashkari raised concerns about weak inflation expectations, citing as one measure the estimates from the University of Michigan consumer survey. Estimates from the New York Federal Reserve, however, are moving higher. Something to keep an eye on.
In short, there are good reasons to expect the Fed to keep singing the same song for the time being. While first-quarter growth estimates are not yet showing the strength implied by survey measures of the economy, they also do not yet give the Fed reason to deviate from its current policy path. With Fed officials not thinking a rate hike is likely until June, policy depends more on the evolution of data in the second quarter than weakness in headline growth for the first quarter.
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