For Jerome Powell, raising U.S. interest rates this week will likely be the easy part.
The tougher job for the Federal Reserve’s new chairman as he presides over his first gathering of the central bank’s policy-setting committee is deciding what to do next.
The choice: emphasize continuity with his predecessor Janet Yellen’s strategy of increasing rates gradually to exploit low inflation for labor market gains, or shift away from it by signaling faster hikes.
“The economy is clearly picking up momentum and there is concern at the Fed that they have gotten caught flat-footed” with a policy rate that is too low, said Mickey Levy, chief economist for the Americas at Berenberg Capital Markets LLC in New York. “Powell will look very similar to Yellen until inflation gets to 2 percent.”
Making the right call is hard for any central banker at turning points like the current one where the economic outlook is brightening. Compounding Powell’s challenge is that he’s new to the role, meaning he must establish credibility among colleagues privately and build it publicly with investors.
Powell and fellow policy makers meet on Tuesday and Wednesday with financial markets pricing a rate increase with certainty. Thirty minutes after the decision is announced, Powell will explain it and present an outlook to reporters. A lot has changed since their last meeting in mid-December.
Republicans passed fiscal stimulus that cuts taxes by almost $1.5 trillion over the next decade. Financial conditions remain easy. More than a half-million jobs were added to payrolls in January and February. Business sentiment indexes are soaring, and forecasts for 2018 U.S. growth are creeping up, while inflation remains stuck below the Fed’s 2 percent target.
The Federal Open Market Committee’s median estimate in December called for three hikes for 2018. Wall Street firms such as Goldman Sachs Group Inc. and UBS Securities predict that the median estimate will be revised up to four this week. Robert Martin, executive director at UBS, calls the March meeting “a nice fat tightrope” for Powell to walk because moving to four hikes “shows consistency” with recent data.
But there is also tension between evidence in hand and what essentially are forecasts, guesses and fears among FOMC participants.
If Powell wants to maintain Yellen’s gradualism, there are a couple of issues raised by FOMC members he will have to push back against. One ghost that’s troubling the FOMC right now is the risk of financial instability.
This perception has crept into the tightening bias of some officials, and it is easy to see why. The past two recessions were caused by bursting financial bubbles that U.S. central bankers were blamed for helping inflate. The question of how to approach financial excess still gnaws at them.
The official strategy is to strengthen banks through tougher regulations, and to occasionally warn against some types of lending. But some see the unusually low policy rate of 1.25 percent to 1.5 percent as a risk. It’s not an irrational fear. Financial conditions have eased after all five rate hikes in the current tightening cycle.
Fed Governor Lael Brainard, as well as Fed bank presidents Esther George of Kansas City and Eric Rosengren of Boston, are wary about the policy setting and how it might be feeding distortions. For all the hand-wringing, there are few bubbles to point to just now, and the effectiveness of a couple of hikes in the policy rate in curbing excesses is a matter of unresolved debate among economists.
For his part, Powell suggested that this isn’t a problem the committee needs to worry about for now. “There’s no evidence that the economy’s currently overheating,” he told the Senate Banking Committee March 1. The report he presented to Congress said, “vulnerabilities in the U.S. financial system are judged to be moderate on balance.” That favors continuity with Yellen’s gradualism.
Another struggle that Powell will referee is determining whether the labor market is too hot. With the unemployment rate at 4.1 percent in February, matching the lowest since 2000, central bankers are worried that compensation costs will start to move fast. There just isn’t much evidence in wages yet that they are. If anything, more people have come off the sidelines into the job market than economists expected to offset retiring baby boomers.
Goldman, JPMorgan See Chance U.S. Unemployment Drops Below 3%
With such uncertainty about the level of full employment, policy makers should put more weight on real indicators such as inflation, said Athanasios Orphanides, a Fed board senior adviser under Alan Greenspan who is now a professor at MIT’s Sloan School of Management.
“If inflation is rising slowly, and still below target, then that would justify the Fed being cautious on tightening,” he said.
Inflation has been crawling below the Fed’s 2 percent target for most of the past five years. Core inflation, by the Fed’s preferred measure, rose just 1.5 percent for the 12 months ending in January, while the full index incorporating food and energy increased 1.7 percent.
Powell appears to have a more subtle approach of exploring the range of where full employment might be rather than coming to hard conclusions, according to his House testimony. He said an unemployment rate that corresponds to full employment could be as low as 3.5 percent or as high as 5 percent, and he seemed open to exploring that range.
“We’ve seen people either not leaving, or coming back into the labor force asit’s gotten tighter,” Powell told the House Financial Services Committee Feb. 27. “How much more of that can there be? You know, I hope there’s a lot more, but I’m not really sure.”