Fed Should Like That Fiscal Stimulus is on Shaky Ground
After an extended period of relative calm, stock prices plunged last week, driven by heightened political risk. Given the seemingly nonstop chaos emanating from the White House, it is easy to imagine that political risk will be a weight around the necks of market participants for the foreseeable future.
But how much of a weight will it be for Federal Reserve policy makers? They will surely take notice, as there are some clear implications for fiscal policy risks, but will they enough to drive expectations of a June interest-rate hike down from a near certainty to as low as 60 percent last week? That seems extreme to me. Absent more severe financial turmoil -- think early 2016 -- the Fed will remain more focused on the path of economic activity than the turmoil in Washington and the attendant gyrations on Wall Street.
A White House mired in controversy seems unlikely to help move forward Republican legislative priorities such as tax cuts. That clearly reduces the odds of a fiscal policy induced growth surge later this year or even in 2018. By extension, that reduces the risk the Fed will accelerate the pace of rate hikes. It doesn’t, by itself, change the underlying pace of growth in the economy. As long as that remains consistent with the Fed’s projections, policy makers will remain committed to their basic interest-rate projections.
The second-quarter data has so far been supportive of the Fed’s forecast. The median central banker anticipates 2.1 percent growth in gross domestic product in both 2017 and 2018, a few notches above potential growth of 1.8 percent. First-quarter growth was weak at 0.7 percent, but that is widely believed to reflect transitory issues with residual seasonality in the data. The Federal Reserve Bank of Atlanta is tracking GDP growth of 4.1 percent in the second quarter.
If that holds, the average for the first half of the year will be 2.4 percent, well above the Fed’s estimate of potential growth and sufficient to place further downward pressure on the already low unemployment rate. An actual pace of growth near 2.4 percent would be more important for policy makers than a diminished chance of fiscal stimulus.
Indeed, the Fed might be happy to take fiscal stimulus off the table for the time being. A faster pace of growth -- assuming it is driven by demand, not supply -- would lead the Fed to consider a faster pace of rate hikes, and with it a higher risk of over-tightening. Moreover, it would place the Fed in the uncomfortable position of leaning against the White House. A steady and moderate pace of growth is in the Fed’s best interest at this juncture.
As far as falling equity prices are concerned, the Fed will be watching more than those declines to evaluate financial conditions. It will almost certainly view the decline in yields on longer-term Treasuries and the associated drop in mortgage rates back to 4 percent as a loosening of financial conditions. The same holds for the recent depreciation in the value of the dollar, which will place upward pressure on inflation forecasts.
Against this backdrop, a one-day drop in equities wouldn’t have much impact on monetary policy. Even a one-week decline would just be a blip on the radar after the rally of recent months. Consequently, it should be no surprise when we hear Fedspeak like this from Cleveland Federal Reserve President Loretta Mester: “You have to look through those temporary fluctuations in both economic and financial data and focus on what the implications are for the medium-run outlook,” she told reporters after a speech in Minneapolis.
What will the Fed care about? Barring a real disruption to financial markets -- again, think early 2016 -- the interplay between growth, unemployment and inflation will be much more important than White House politics.
On the growth front, the current pace of activity argues for a faster pace of tightening (but watch for signs that consumer spending could slump in the back half of the year as households struggle with rising debt loads). The same goes for unemployment. It’s already below Fed forecasts for this year.
But inflation is telling the opposite story. If the economy were truly operating near capacity, we wouldn’t expect the softness we see in the inflation numbers. Persistently low inflation suggests the Fed’s estimates of full employment are too pessimistic and thus argues that the central bank is too far ahead of the inflation curve.
How the Fed balances these competing signals is the key to understanding monetary policy going forward. The chosen balance appears to yield a Fed that is on something of autopilot. As long as the current equilibrium holds, they plan to tighten policy gradually but quite frankly fairly predictably. For the moment, a hobbled White House is a second- or third-order concern.
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