Next Fed Chair Will Contend With a Slow-Growth Economy
The U.S. appears set to enter a more risky phase of the business cycle as the Federal Reserve attempts to glide the economy into a so-called soft-landing. For President Donald Trump's likely nominee as chair, Jerome Powell, this means tightening policy enough to settle the economy into full employment, but not so much that it trips into recession.
Navigating this transition will be challenging for investors and the Fed alike. Market participants should be wary of assuming that a slowing economy means a recession is near. At the same time, central bankers need to be wary that they don’t slow the economy too much and set the stage for the next recession. Altogether, this means the relative calm of the past year is likely to end soon.
The economy grew at 3.1 percent in the second quarter and 3 percent in the third, the best back-to-back performance since 2014. Can it last? The Fed doesn’t think so. The recent pace of growth exceeds the central bank's estimated longer-run pace of 1.8 percent, the median estimate of policy makers in the Fed’s Summary of Economic Projections. Given that the Fed believes the economy is operating at or somewhat beyond full employment, a sustained 3 percent pace would, in the bank's world, stretch capacity too far and generate excessive inflationary pressures.
To counter these forces, the Fed anticipates continued tightening of policy, on the order of 100 basis points between now and the end of next year, to slow growth to a still high but more manageable 2.1 percent rate in 2018.
The 100 basis points of rate increases, however, are a projection, not a promise. The next Fed chair will need to deftly handle the transition to a slower-growth economy. One big challenge will be gauging the pace of any slowdown. During the early stages of an expansion, the picture told by most economic data is usually one of stronger growth. As the expansion matures and slows, however, the data become more muddled.
Employment growth, for example, will continue to slow, descending to a pace closer to 100,000 jobs a month. This means more sub-100,000 readings, which are typically viewed as weak during the earlier stages of an expansion. Auto sales appear to have peaked for the cycle and may trend lower. The recent surge in business equipment spending may fade. Banks may experience more delinquencies on consumer debt.
These are just a few examples. The point is that the tenor of the data will shift, and this shift could be misinterpreted as a recessionary signal. At the same time, though, the transition to slower growth could leave the economy more vulnerable to negative shocks and actual recession, making it all the more important that the Fed is able to nimbly switch from tightening to easing should the need arise.
Moreover, the Fed may face a different challenge. It may be that companies operating near capacity take the plunge and expand their operations, boosting growth. Alternatively, Congress may manage to agree on a substantial tax cut, supporting consumer spending. Or, with the economy already operating above full employment, more inflationary pressures exist than currently evident. These circumstances might require a more aggressive pace of rate hikes.
And then there is the possibility of an acceleration of productivity growth, which, in turn, would boost the Fed’s estimate of the longer-run growth rate. This could place policy makers in a tricky position because, in the near term, it might argue for a slow pace of rate increases, but over the longer run we would expect faster productivity growth to push the neutral rate higher. Eventually, the Fed would need to follow with an aggressive tightening stance.
This is why reading the data and setting monetary policy are likely to become more difficult next year. During a recession, the policy choice is obvious: Cut rates. At some point during a recovery, the policy choice becomes obvious: Begin raising rates. But as the economy reaches full employment, the Fed needs to fine-tune policy while sorting through possibly conflicting economic data. Chair Janet Yellen had a pretty easy environment to work with in 2017. Her successor probably won't be so lucky.
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