The slow growth the US experienced in the first quarter was described as only a transitory phenomenon. The excuse that the slow growth is short lived was used to justify monetary policy that looked past the soft patch. But the economy is not expected to rebound much in the second quarter.
Was there more than met the eye to the slow growth? Probably not. Instead, the likely answer is simple: The US economy is growing slowly—but steadily. And in the end, it is likely GDP will again be weak.
Granted, it’s not all bad news for the economy. For almost every disappointment, there is a positive data point to counter the pessimism. Take the employment data for example. Many of the employment indicators are truly positive.
For quite some time, the data had been so weak, expectations for improvement kept moving lower and lower. Surely, at some point the bad news would cease. Well, the recent data has also not been good.
But this may be changing as forecasters and markets adjust to a slower pace of policy change and less accommodative monetary policy. With lower expectations, positive surprises should become frequent. Again, this is not just because the data is that much better. It is mostly because hope has moved lower.
Inflation is probably the most important number for the Fed’s monetary policy. It has been weakening. And not because of a single, transitory line. Instead, the weakness is spread across a range of items. Taking the core (ex: food and energy) inflation figure, removing shelter reduces the inflation reading to only 0.6% from a year ago.
This is a sort of super core that gives us an idea of how widespread the weakness truly is. The Fed's projection that inflation weakness is short lived—at this point—is nothing more than hope. Chances are increasing that the inflation pressures are not short term. And any problems with shelter will reverberate through Fed policy.
Markets have reacted to the disappointing data by pushing the dollar lower. US debt yields have also gone down. This is a logical reaction. But do these data readings change much in terms of Fed policy? Probably not. Instead, the Fed remains adamant that this is transitory. This stubbornness will have consequences.
The Fed, including Chair Yellen, have made it clear that low inflation readings will be considered transitory until they rise toward 2%. This is largely meant to signal that the balance sheet reduction will start this fall.
The Fed is far less concerned with the pace of future rate hikes. After all, the Fed is quickly getting near its target of being at the neutral rate.
And this is where the Fed’s recent communication is important in understanding how its thinking is evolving. Or, as in the current case, potentially becoming more entrenched.
The Fed minutes from the June meeting were intriguing from a number of angles. The most intriguing being that there was an overt debate between the macroprudential arm of the Fed and the “anti-Volckers.”
One portion of the minutes showed (emerging) concern over the effects of loose monetary policy on asset prices. Another section summarized the argument for undershooting the sustainable level of unemployment to encourage higher wages and inflation. The macroprudential arm would raise rates to quell imbalances their loose policy might be encouraging.
It would appear that the core of the Fed is leaning toward the macroprudential approach. After all, unemployment is low and the recent readings on the health of the US economy from Institute for Supply Management surveys show the US economy is growing at a healthy clip.
After the June meeting, Yellen made it clear the Fed was looking beyond low inflation readings. So there is little to stand in the way of the Fed tightening further.
But we should not jump to conclusions. Nowhere in the minutes or recent speeches have Fed officials moved away from their stance of moving toward “neutral.” In Fed-speak, this means removing accommodation but not tightening. A neutral stance sitting somewhere between 1.5% and 2% on fed funds. This is part of the reason the Fed believes it can both get its 2% inflation and raise rates too.
One reason the Fed wants neutral and not tighter policy is wage growth and inflation. But this is also the argument for looser for longer.
Until recently, lower unemployment rates were associated with higher inflation. But this correlation seems to be breaking down. So, the debate will rage on about how the Fed should approach its policy stance.
Part of the debate is the virtuous cycle (or lack thereof) between wages and inflation expectations. From the Fed minutes:
[P]ossible benefits cited by policymakers of a period of tight labor markets included a further rise in nominal wage growth that would bolster inflation expectations and help push the inflation rate closer to the Committee's 2% longer-run goal…
In other words, there may be benefits to holding rates at or below neutral.
But this is a debatable point. It does not appear that the “loose for longer” group at the Fed is winning. Instead, the macroprudential policy adherents seem to be the core. This could change as new members of the Fed are appointed, but tightening to neutral is the current policy path. Regardless of what the data does.