The Fed: Look Forward or Risk a Hawkish Mistake

Will the Federal Reserve take a hawkish turn at its next meeting ending on 26 September? There are signs it may. Although we expect the Fed to hike rates by 25 basis points, to 2.0% to 2.25%, that’s not our concern.

Rather, there is growing evidence that some (not all) Federal Open Market Committee (FOMC) participants are de-emphasizing forward-looking projections when assessing the near-term path of monetary policy, preferring instead to focus on incoming economic data. The continued gradual pace of hikes currently prescribed by that approach is OK when the federal funds rate is still below the range of estimates for neutral policy. However, we worry that a policy strategy that continues to hike interest rates until there are clear signs of economic slowing could lead to an overtightening mistake. As we’ve discussed previously, the Fed has the tough job of balancing the risk of overtightening policy with the risk of overheating the economy.

More data, fewer models?

In mid-September, the historically cautious Federal Reserve Board governor Lael Brainard hinted at more hawkish policy in an address to the Detroit Economic Club. She said that monetary policymakers should focus on the shorter-run neutral interest rate (the rate at which output grows near potential with full employment and stable inflation) rather than the longer-run neutral rate, which also typically drives the Fed’s assessment of the stance of monetary policy. This approach, she said, argues for continued gradual rate hikes.

The shorter-run neutral rate is more sensitive to current conditions and has recently increased as growth has accelerated and the Fed has hiked rates – and it’s likely to rise above the longer-term neutral rate in the next year or two. The fundamental issue with the shorter-run neutral rate is that it’s sensitive to backward-looking economic data and is being boosted by factors that are very likely to prove temporary, including the meaningful U.S. fiscal stimulus. And while it’s possible that recent U.S. tax reforms will result in higher trend growth, we think it’s too early to tell.