Vanguard's Chief Economist
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When Jerome Powell presides over his first Federal Open Market Committee meeting as the new Federal Reserve chairman on March 20–21, the seat will be less comfortable than it was just two months ago, when the U.S. Senate approved his nomination.
Since then, the rollout of new tax legislation, the resolution of near-term debt-ceiling dramas, and a rise in aggressive trade proposals have plucked stuffing from the seat cushion. The developments create new uncertainties about Fed policy and put a premium on crystal-clear communication from the chair.
Our take: The Fed is all but certain to raise interest rates next week. Powell’s postmeeting news conference will be the main event. We expect him to outline a plan that calls for three rate increases in 2018 and three more in 2019. Powell’s biggest challenge will be to make clear that while market conditions warrant steady hikes, the federal funds rate target will remain well below its levels over the past 40 years.
Tighter, but not too tight
Late last year, our economics team signaled in its outlook for 2018 that the labor market might well deliver an inflation surprise, triggering changes to the long-standing status quo of high asset prices and eerily low volatility.
Strong jobs reports in January and February suggested that this scenario might indeed be unfolding. Average growth over the past six months is now over 200,000—a notable result at this stage in the business cycle, with unemployment at a 17-year low of 4.1%. Year-over-year growth in average hourly earnings remains reasonable given low productivity and low inflation, but it’s expected to accelerate as the labor market tightens further.
Other indicators have also hinted at an inflation pickup. Consumer prices ticked higher in January and February. The dollar’s weakness has contributed to higher import prices. And from the minutes of the Fed committee’s January 30–31 meeting, we know its members now believe that the significant fiscal stimulus from tax cuts and increased federal spending could affect growth in the near term more than they initially thought—especially with the economy already expanding at an above-trend pace topping 2.5%.
Wanted: Nuanced communication
Our concern is that markets will respond to signs of inflationary pressures and uncertainty by anticipating overly aggressive estimates for the ultimate fed funds rate level. A consequence would be more market volatility as prices adapt to a higher-rate future.
And this is where the communication gets tricky.Rates are going higher, but not too high.The message is nuanced, and for the Fed to deliver it will demand an acrobatic sense of balance.
Don’t confuse the cycle with the trend
Our research indicates that any inflation pressures we feel in the next few years will be cyclical. The economy’s long-term growth and inflation prospects remain subdued relative to historical standards. A shrinking labor force, technological disruption, and expanding globalization are likely to keep trend growth for the U.S. economy at about 2%. And although tailwinds may push inflation higher in the short term, those forces will make achieving 2% inflation difficult over the long term.
Recent developments haven’t led us to change our forecasts. The Fed chair has never been a recliner. But today’s combination of cyclical economic changes and policymaking volatility in other sectors of government make the chair especially uneasy.