As we at Cumberland Advisors expected, the FOMC left its policy rate unchanged for the moment and announced that it would begin the process of normalization of its balance sheet in October. They have a plan. It has been well-articulated. There were no surprises, and the Committee and Chair Yellen indicated that they did not anticipate any surprises. Consequently, the market’s reaction to this announcement was modestly positive. Finally, given the decision and the Committee’s Summary of Economic Projections (SEPO), the odds of a rate hike in December have increased.
Why do we think that the more likely rate hike is now in December rather than October? The answer is that the Committee is cautious, and with inflation still running persistently below target, it can afford to be patient. At its October meeting the Committee will have only the first reading on Q3 GDP and will have some preliminary clues on the impacts of the hurricanes, plus a reading on September employment. That number will be speculative until the extent of the knock-on effects of the hurricanes can be determined and assessed. Recent presentations at the NABE annual meeting now suggest that the impacts will be less than initially forecast. Finally, by December, there will be a refined estimate of Q3 GDP, three more labor market job reports, and a revised set of SEP forecasts to weigh against any new information on inflation. By waiting the Committee will better be able to assess the accuracy of its forecasts for the near term.
The more interesting information from this last FOMC meeting is the insights we gleaned after the meeting, both from the SEP forecasts and from Chair Yellen’s press conference. The picture we get is s the FOMC’s view is that the economy is growing steadily and the labor market continues to improve, but the response of inflation has the Committee totally puzzled. Consider the Committee’s GDP forecasts. The highest median forecast is for 2.4% growth for 2017, followed by a gradual decline year by year to 1.8% in 202 Labor markets are projected to remain tight, with the median unemployment rate declining even more, from 4.3% to between 4.1% and 4.2%. Finally, the median PCE inflation measure is expected to move up to 1.9%, within striking distance of the Fed’s 2% target.
The problem is that GDP is weaker and labor markets are not significantly different in these new forecasts from what has happened in 2017. So where do the inflation pressures come from? The question is especially interesting when we look at the distribution of the federal funds rate target that FOMC participants argue is most consistent with their forecasts. For example, the median outcomes are realized with a policy rate for 2018 ranging between 1.9 and 2.6%. (We are ignoring here the 1.1% number submitted by one participant.) The range of assumed target rates for fed funds in 2019 is between 2.4% and 3.4%, while median GDP growth is even lower, at 2%, from that projected for 2018. All the while, inflation is seen as pushing close to the Committee’s 2% objective. This view of inflation dynamics implicit in the SEP forecasts simply doesn’t comport with what has happened and implies that substantially different underlying forecast models and inflation dynamics are being utilized by FOMC participants.
Is there an alternative, understandable explanation for the inflation path we have seen? Simple Econ 101 supply and demand analysis may hold the answer. The picture we have right now is of a real economy in which GDP growth is slow both because of slow growth in the labor supply and low productivity. If, in such a world, aggregate demand is essentially in balance with production and there is no excess demand, then there can be no upward pressure on prices. People are simply not running around trying to spend but failing to find goods and services. If producers can’t raise higher prices in the face of non-existent excess demand pressures, then prices will not move up. Moreover, there will be no need to bid up wages. If this simple explanation works, then the FOMC’s clinging to a 2% inflation objective that is inconsistent with demand and production becomes a risky policy. This likely explains the wide range of policy rate assumptions FOMC participants are making and reflects the widely differing views within the FOMC as to what is appropriate policy going forward.
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