The Fed Reaches for the Stars

  • This week, the team looks at what’s ahead for the Fed

Federal Reserve Chairman Jerome Powell used a celestial metaphor to center his remarks at the recent Jackson Hole summit. The Fed’s decisions, he noted, are often based on the distance of inflation, unemployment and growth from their long-run equilibria. In modeling shorthand, these long-run levels are known as “stars.”

“Navigating by the stars can sound straightforward,” said Powell. “Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly.”

The stars certainly seem aligned in support of an interest rate increase next week, which is widely anticipated. But the market’s telescopes will be looking for indicators of how much farther the Fed has to go before reaching its ultimate destination.

Here is our take on the likely content of next week’s conversations.

The U.S. economy had good momentum entering 2018, and thanks to the Tax Cuts and Jobs Act of 2017, activity has accelerated. The second-quarter results are unlikely to be repeated (there was a surge in exports as firms tried to beat upcoming tariffs), but the economy is on pace for real growth of 3% for the full year. Our latest forecast can be found here.

Growth in the coming quarters will be tempered as the cost of trade actions becomes apparent. Tensions have diminished with the EU and Mexico, but an extensive new round of tariffs on Chinese products was announced this week. Estimates suggest that trade restrictions could reduce real gross domestic product (GDP) growth by 0.5% next year, a sizeable amount.

Household debt has moderated in the last decade, and corporations are awash with cash released by tax reform. So interest rate increases from the Fed may not be having the same dampening effect that they have in the past. Overall, financial conditions have actually gotten easier since the Fed began raising rates in 2015.