Written by Jim Welsh
The Federal Reserve has been roundly criticized for increasing the federal funds rate at its December 19 meeting and for publishing its dot plot which anticipates two more rate increases in 2019, even though GDP growth is slowing.
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It should be noted that the FOMC’s projection for GDP growth in 2019 was 2.4% at the March and June 2018 meetings and 2.5% in September. The projections for 2018 GDP were 2.7% in March, 2.8% in June, and 3.1% in September. At the December 19 meeting the FOMC lowered its estimate for 2018 to 3.0% and to 2.3% for 2019.
The changes in its GDP projections for 2018 and 2019 indicate that the FOMC has been responding to incoming data all along. This suggests that if economic data comes in weaker in 2019 than the FOMC expects the dot plot will not be adhered to. In 2016 the dot plot projected three increases in the funds rate but the FOMC only increased it once. The dot plot is a communication tool and not a policy tool.
After the December 19 meeting investors concluded that the dot plot indicated the FOMC would increase the funds rate no matter what. This reveals a complete lack of understanding of how the FOMC has proceeded in recent years.
Prior to the December 19 meeting a growing number of investors were expecting (hoping) that the FOMC would increase the funds rate and then communicate that it was pausing for a period of time.
This expectation shows a naïve view of how the FOMC operates. There was absolutely no way the FOMC would shift from communicating 3 hikes in 2019 to none. Instead the FOMC lowered its projection for GDP growth from 2.5% to 2.3% and reduced the expected number of increases from 3 to 2. This is the FOMC’s way of telling investors that it recognizes and acknowledges that growth is slowing and will be responsive to incoming data.
By communicating in this manner the FOMC retained its optionality. Just as they don’t want to be boxed in by the dot plot, they wouldn’t want to publically hit pause and then risk having to communicate the need to resume hikes if incoming data proved stronger than expected. The FOMC has been increasing rates once a quarter since December 2017 which implies another hike in March 2019. Based on how the FOMC communicated its outlook for 2019, the odds of an increase in March are very low.
I think the FOMC is pausing for three reasons:
- They want to see how pronounced the slowing becomes and whether it proves temporary.
- The FOMC wants to know how the tariff and trade negotiations will impact growth after the March 2 deadline.
- Finally, one of their primary goals has been to increase the funds rate to a neutral level so monetary policy is neither accommodative nor restrictive, and where growth and inflation are both at their natural rate on a stable basis.
By raising the funds rate at the December meeting the FOMC knows it is close enough to neutral to pause since there is no qualitative way to precisely measure the neutral rate.
Prior to the December 19 meeting there was a vocal but minority chorus of those who thought it was inappropriate given the weakness in the U.S stock market for the FOMC to increase the funds rate. Historically, the real federal funds rate has been 2.0% above inflation. With inflation hovering near 2.20% and the federal funds rates at 2.20% prior to the December meeting, the real federal funds rate was 0%.
The U.S. economy is in the tenth year and second longest recovery since World War II. The unemployment rate is 3.7% a 49 year low and inflation is hovering at the Fed’s target of 2.0%. The Federal Reserve has achieved its mandate of maximum employment and stable prices.
The current rate of GDP growth is well above the Fed’s estimate of the economy’s long run potential growth rate of 1.8% and will remain above it even if GDP growth slows to 2.3% in 2019. Under the current circumstances the FOMC determined it was inappropriate for the real federal funds rate to be 0%.
In June 2017 Fed Chair Janet Yellen said the unwinding of the Fed’s balance sheet would be like “watching paint dry.” Prior to December 19, 2018 one could agree Yellen’s comment was accurate.
Chairman Powell has been strongly criticized for saying the shrinkage of the Fed’s balance sheet which began in October 2017 was on autopilot. Clearly, Powell and the other members of the FOMC have seen nothing to suggest the unwinding of the balance sheet was causing any economic or financial disruptions.
There have been estimates that suggest the balance sheet unwinding is comparable to additional increases in the federal funds rate. The logic is straightforward. Quantitative Easing (QE) added liquidity to the financial system and effectively lowered the federal funds rate below 0%. According to the Federal Reserve of Atlanta QE effectively lowered the Shadow Funds rate to minus -3.0%.
It follows then that Quantitative Tightening (QT) not only removes liquidity but also equates to a higher federal funds rate.
There is no play book since the Federal Reserve had never before used QE so the full affect of QT is not known. One thing is for certain. Given the attention QT has received since December 19, the FOMC will be reviewing the process and deliberating under what conditions its $50 billion a month QT should be modified.
I doubt the FOMC will specifically say QT is being reviewed but Fed presidents and FOMC members may comment that every aspect of monetary policy is always viewed in the context of incoming economic data. In all likelihood the FOMC will conclude that QT does represent a higher federal funds rate than the official policy rate and determine that the current federal funds rate is at the mythical neutral rate. If this argument is correct the FOMC has another reason to pause and not increase rates in March.
Finally, some strategists have proclaimed that the FOMC had to increase the funds rate at the December meeting to show their independence after so many Tweets from President Trump criticizing the Fed for prior increases. This criticism borders on silliness and demeans the integrity, dedication, and absolute resolve the members of the FOMC possess in trying to do the best they can in conducting monetary policy.
This does not mean they will get it right. But to suggest that the FOMC would change the path of policy in response to sophomoric tweets illustrates such a shallow level of critical thinking and understanding by anyone espousing such nonsense. These folks have a fondness for conspiracy theories and would be happy to share all of them to anyone dumb enough to listen.
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