Recent comments from senior Fed officials have given the impression that they are looking to pause (or even end) the tightening cycle once interest rates hit neutral levels. This could come around the middle of 2019 after two or three more hikes. However, for the Fed to pause they would need to see growth slow sharply or inflation pressures stabilise and neither looks very likely. Even so, the pace of monetary tightening seems likely to slow.
Policy settings should remain positive for growth for at least the first half of 2019. Fiscal policy is stimulative and interest rates are still below neutral. Tariffs will be a small drag, but affected imports are only just over 1% of GDP and the recent Trump-Xi talks give hope of avoiding escalation. US GDP growth would need to slow to below 2% from around 3% in 2018 in order to halt the decline in the unemployment rate. It is hard to see the mechanism that would cause this to happen.
Financial conditions have tightened as a result of recent market turbulence, but the move is not so large that it is likely to be a big headwind to growth or drive a material shift in policy.
US financial conditions (higher or looser)
There is a more reasonable hope that steady 2% inflation allows the Fed to pause, partly because overall prices have been sticky and partly because some components are driven by idiosyncratic factors rather than the broader economy, which gives an element of randomness (although this can cut both ways).
If inflation is still close to 2% by the middle of 2019 then the Fed could justify a pause, especially as fiscal policy is set to drag on growth going into 2020. Recent data is encouraging, as it does not show accelerating inflation. The Fed will ignore the direct impact of lower oil prices, but cheaper energy will still help via the indirect effect on other prices.
US core inflation steady around the 2% level
However, an orthodox economic model would say that when unemployment is low, policy is loose and growth is above trend, then inflation should rise. This is our base expectation and it is why we doubt that the Fed will be able to take an extended break from its rate hike cycle next year, even though it can probably go more slowly.
The next two or three hikes look very likely – after that it is more uncertain. Our base case is that we will see another hike in December and then three more in 2019. We think the Fed wants to escape from the predictability of the past two years, which saw a policy move every three months. This will be more feasible now that a press conference is scheduled after each meeting. So a pattern of (say) March / July / October or May / July / December is possible.
However, at some point interest rates are likely to need to go above neutral levels in order to slow down the economy and pull the unemployment rate up towards more sustainable levels. This suggests that even if the pace of hikes slows in 2019, we should expect policy to continue to tighten into 2020.
Judging the neutral level of interest rates is imprecise, with the range of Fed estimates between 2.5-3.5%, with a median of 3.0%. So it is not particularly informative when Fed Chair Powell notes that rates are “just below the broad range of estimates of …. neutral”.
There are even some claims that interest rates are already at neutral levels, with the soft housing market cited as evidence. However, housing affordability is still good by historical standards, while the weakness has been concentrated in areas most affected by recent tax changes that limited mortgage deductibility. The bulk of the economy and financial markets are not giving many signals that monetary policy is tight, although the late-cycle fiscal stimulus has clouded the picture.
It is possible that if consumers’ inflation expectations are as stable as the Fed claims, then firms will hold back on price increases. Unfortunately, this restraint is not evident in the labour market, where wage growth is picking up, and already running at the fastest pace this cycle. It seems hard to argue that consumers have stable price expectations, but workers do not, as they are two sides of the same coin.
Alternatively, if wages rise but firms are unable to pass on the rising costs through higher prices, then the implication is that there is more of a profit squeeze than usual.
If the Fed intends to pause in 2019, then we could see further guidance at the 18-19 December policy meeting. This could come in the policy statement, in Powell’s press conference or in the “dot plot” for 2019 and 2020. Currently nine FOMC members think that three or more rate hikes will be warranted in 2019, while seven think two or fewer are needed. Clearly, it does not take much of a shift in opinion to push the median down from three to two hikes. The Fed is currently looking for one more hike in 2020.
There is also an interesting question of how financial markets might view a dovish shift in the “dot plot” at the next meeting. A signal of fewer rate hikes in 2019 could be taken positively, as reducing the risk that Fed tightening kills the recovery. Alternatively, given the nervous state of the market, it could be read negatively as “what do they know about the cycle that we don’t?”
Some sign of higher inflation expectations
The Fed has said policy will be reactive, so new information on inflation will be the best guide to whether a pause is possible. The Fed will be concerned about recent signs that inflation expectations are edging higher, and this could develop into an argument against a pause.
Our base expectation for 2019 is that the unemployment rate continues to fall, while inflationary pressures continue to edge higher. This prevents the Fed from taking a break from its hiking cycle, but it is able to move more slowly as rates near neutral levels, in an attempt to guide the economy towards a soft landing.Disclaimer applicable to recommendation
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