Fed: policy will need to be tightened gradually through to 2020 - Westpac

Analysts at Westpac explained that the revised forecasts from the FOMC and the tone of communications highlight that the Committee continue to anticipate policy will need to be tightened gradually through to 2020 as the economy experiences above-trend growth and 2.0% inflation nears.

Key Quotes:

"Following consistent strength in the labour market through 2017 and into 2018, the unemployment rate forecast has been revised down to: 3.8% by end-2018 (from 3.9%); 3.6% by end-2019 (from 3.9%); and 3.6% by end-2020 (from 4.0%). The longer-run expectation remains circa 4.5%. At face value, this set of forecasts implies that ‘full employment’ will be easily surpassed, and hence that wages and inflation will accelerate sharply. Yet, based on the Committee’s inflation forecasts and the tone of wage discussions, this is clearly not their central case.

On core inflation, only the median for 2019 and 2020 have been lifted, and only by 0.1ppts to 2.1%. Inflation at that level would be not be a concern for policy given their target is symmetric – particularly after such a long-lasting undershoot of 2.0%.   

From the discussion on wages in the Q&A, it is evident that there remains uncertainty over why wages have not yet accelerated materially. One reason could be that the ‘neutral rate’ is actually much lower than anticipated, with slack still to be worked through. This would fit with the still-low level of prime-aged participation – a feature of the labour market we continue to highlight.

On growth, although "recent data suggest that growth rates of household spending and business fixed investment have moderated from their strong fourth-quarter reading", the FOMC remains optimistic, focusing instead on the outlook. Here the recent tax and spending packages approved by Congress are key, resulting in an upward revision to growth in 2018 of 0.2ppts to 2.7% and for 2019 of 0.3ppts to 2.4%. Both years are now expected to see growth well in excess of trend/ potential growth, typically estimated as 1.75%. In the eyes of the FOMC, as notable as this strength is, it will prove temporary. Growth will subsequently retreat to 2.0% in 2020, then 1.8% in the longer-run.

How does all of this fit together for policy? Simply the best course of action is to plot a gradual tightening path and remain cognisant of the risks. On the FOMC’s median expectation, this means three hikes in 2018, another three in 2019, and two in 2020. Relative to the December meeting, the 2018 forecast is unchanged, and the 2019 view edged higher – to fully price the third hike. 2020 is where the most significant change is, a full hike being added. That the longer-run rate of 2.9% was little changed in March despite the lift in the 2020 view implies that the Committee expect to have to tighten past neutral and make policy restrictive for a time.

This view finds its basis in a lingering concern over inflation. As the textbooks would argue, the FOMC is holding on to the view that, if growth remains materially above trend for a sustained period (in this case four years including 2017), then inflation will inevitably threaten to break out. That inflation is the only risk called out by name in the statement highlights this. Further, though the median fed funds forecast did not change for 2018, it would have only taken one more Committee member revising up their view to make it so. (To put it another way, between December and March, three voters shifted to four or more hikes.)

We argue that it is prudent to retain the gradual approach to policy and see how the data prints. Hence, we look for three hikes in 2018 and two more in 2019. During that time, inflation and the other critical factor for policy (financial conditions) can be assessed. Should inflation surprise to the upside, or financial conditions fail to tighten, then the FOMC will have cause to become more aggressive. Only time will tell how growth, inflation and financial conditions will react, and how policy should respond."