Edward Harrison is the founder of the blog Credit Writedowns and is a finance specialist at Global Macro Advisors. Previously, Edward was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. He started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. Edward holds an MBA from Columbia University and a BA in Economics from Dartmouth College.
I mentioned an upcoming Lael Brainard speech a week ago. She’s the Federal Reserve Governor to watch because when she gets on board policy, it shows consensus. And this week she gave a speech whose very title suggests a regime shift in US monetary policy. The full “Speech by Governor Brainard on navigating monetary policy as headwinds shift to tailwinds ” is on the Fed’s website. But I am going to give you a play by play here and tell you what it means for policy. The short answer is it means the Fed will be more aggressive in tightening going forward. The analysis follows below.
Let’s put post-crisis monetary policy in the US into five distinct phases. Each of these represent monetary policy regime shifts, like the one we are now seeing.
The policy regime has ended. New Fed Chair Jerome Powell used his first public remarks before Congress to say so. His view: “While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds”.
Don’t let the understated language fool you. This one sentence encapsulates a marked shift in tone. And now policy dove Lael Brainard is onboard too. The fact that she is giving the first major speech after Powell echoing the same theme is significant. It tells you that the messaging is coordinated. And it also tells you that there is a general consensus on that messaging.
This is a really important speech. So, let’s pick apart what Brainard said line by line. I will translate from Fedspeak to normal speak.
Many of the forces that acted as headwinds to U.S. growth and weighed on policy in previous years are generating tailwinds currently. Today many economies around the world are experiencing synchronized growth, in contrast to the 2015-16 period when important foreign economies experienced adverse shocks and anemic demand…
Translation: I told you in 2017 that I was I was a dove at the time for that reason.
Now, things are different. The macro outlook supports robust business spending. And the only reason the dollar is declining is because things are so good abroad. Other central banks are going to tighten too.
Financial conditions are currently supportive of economic growth despite the recent choppiness in financial markets and some tightening since the beginning of the year. Various measures of equity valuations remain elevated relative to historical norms even after recent movements, and corporate bond spreads remain quite compressed. This compares with the period from mid-2014 through the second half of 2016, when equity prices were flat and the dollar rose steeply. The Federal Reserve Bank of Chicago’s National Financial Conditions Index provides a useful summary statistic. According to this measure, financial conditions tightened significantly from the middle of 2014 to early 2016. By comparison, financial conditions today remain near the accommodative end of the range since the financial crisis, even with the recent tightening in conditions.
Translation: So what if we recently had a correction? Things still look pretty good to us at the Fed. In fact, you could say valuations are stretched. And if you compare today to how things were during the shale oil bust, we’re on easy street. I’m concerned.
The most notable tailwind is the shift in America’s fiscal policy stance from restraint to substantial stimulus in an economy close to full employment. In the earlier period, the economy had just weathered a challenging adjustment to a sharp withdrawal of fiscal support. Today, from a position near full employment, the economy is poised to absorb $1-1/2 trillion in personal and corporate tax cuts and a $300 billion increase in federal spending. Estimates suggest December’s tax legislation could boost the growth rate of real gross domestic product (GDP) as much as 1/2 percentage point this year and next. On top of that, the recently agreed-to budget deal is likely to raise federal spending by around 0.4 percent of GDP in each of the next two years.
Translation: Do you recall Bernanke and Yellen screaming about the “withdrawal of fiscal support”? That left the Fed in an uncomfortable position in fulfilling its dual mandate. We had to offset that. But now, just when we’re basically at full employment, the fiscal taps have opened full bore. We’re talking huge numbers. I don’t say it explicitly, but we’ll offset that too. In fact, fiscal policy is the “most notable tailwind” for the US economy.
Although the economy is currently around full employment and has been expanding at an above-trend pace, inflation has remained subdued for quite some time. Over the past year, overall PCE (personal consumption expenditures) inflation was 1.7 percent, and core PCE inflation was 1.5 percent–not very different from the average level of core inflation over the past five years.
The persistence of subdued inflation, despite an unemployment rate that has moved below most estimates of its natural rate, suggests some risk that underlying inflation may have softened. While transitory factors no doubt played a role in last year’s step-down in core PCE inflation, various empirical analyses conclude that persistent factors are at play in the stubbornly low level of core inflation…
Thus, it is important for monetary policy to ensure that underlying inflation is re-anchored firmly at 2 percent…
Translation: It’s strange that inflation has been so weak since we’re at near full employment. You can call the factors “transitory” as Chair Yellen has done. Still, numbers crunchers say there are deep-seated factors holding inflation back. In the end, we simply aren’t meeting our inflation mandate and we intend to do that.
It is difficult to know with precision how much slack remains in the labor market. If the unemployment rate were to continue to fall in the coming year at the same pace as in the past couple of years, it would reach levels not seen since the late 1960s. On the other hand, the employment-to-population ratio for prime-age workers remains more than 1 percentage point below its pre-crisis level. If substantially more workers could be drawn into the labor force, it would be possible for the labor market to firm notably further without generating imbalances. But it is an open question as to what portion of the prime-age Americans who are out of the labor force may prove responsive to tight labor market conditions because declining labor force participation among prime-age workers predates the crisis, especially for men.
Translation: I say we’re near full employment. The US unemployment rate is near 50-year lows, after all. But, really, this isn’t an exact science. We simply don’t know what constitutes full employment given all the people who’ve left the labor force.
Although last year we faced a disconnect between the continued strengthening in the labor market and the step-down in inflation, mounting tailwinds at a time of full employment and above-trend growth tip the balance of considerations in my view. With greater confidence in achieving the inflation target, continued gradual increases in the federal funds rate are likely to be appropriate.
…Of course, it is conceivable we could see a mild, temporary overshoot of the inflation target over the medium term. If such a mild, temporary overshoot were to occur, it would likely be consistent with the symmetry of the FOMC’s target and could help nudge underlying inflation back to our target. Recent research has highlighted the downside risks to inflation and to longer-run inflation expectations that are posed by the effective lower bound on nominal interest rates, and it suggests the importance of ensuring underlying inflation does not slip below target in today’s new normal.
We also seek to sustain full employment, and we will want to be attentive to imbalances that could jeopardize this goal. If the unemployment rate continues to decline on the current trajectory, it could fall to levels that have been rarely seen over the past five decades. Historically, such episodes have tended to see elevated risks of imbalances, whether in the form of high inflation in earlier decades or of financial imbalances in recent decades. One of the striking features of the current recovery has been the absence of an acceleration in inflation as the unemployment rate has declined, a development that is consistent with a flat Phillips curve. Although wage gains have seen some recent improvements, they continue to fall short of the pace seen before the financial crisis.
However, we do not have extensive experience with an economy at very low unemployment rates and cannot be sure how it might evolve. In particular, we will want to remain attentive to the risk of financial imbalances. While asset valuations appear to be elevated, overall risks to the financial system remain moderate because household borrowing is moderate, risks associated with liquidity and maturity transformation have declined, and, importantly, the banking system appears to be well capitalized. History suggests, however, that a booming economy can lead to a relaxation in lending standards, and the attendant excessive borrowing can complicate the task of monetary policy. We will need to be vigilant.
Translation: It’s pretty much all tailwinds now, folks. I am now hawkish. A regime shift is at hand. First, let me say, we’ll be gradual about raising rates. And even if inflation goes above 2% for a bit of time, I’m comfortable with that because lowflation and zero rates are a toxic mix.
Second, let me say, the Fed’s watching the unemployment rate because some of us think it’s low enough to stoke inflation. The reality is that unemployment doesn’t get this low often. So, frankly, we don’t really know if there is a trade-off between inflation and unemployment.
But, you remember I told you that financial markets were booming despite the correction? That’s a big concern for us. The Fed’s supposed to take away the punch bowl because we know bankers relax standards late in a business cycle. The good thing is that, unlike in 2007, households aren’t leveraged up and banks have more capital. But we’re watching.
What do these considerations imply for the path of monetary policy? Continued gradual increases in the federal funds rate are likely to remain appropriate to ensure inflation rises sustainably to our target and to sustain full employment, keeping in mind that interest rate normalization is well under way and balance sheet runoff is set to reach its steady-state pace later this year. Of course, we should be ready to adjust the path of policy in either direction if developments turn out differently than expected.
In many respects, the macro environment today is the mirror image of the environment we confronted a couple of years ago. In the earlier period, strong headwinds sapped the momentum of the recovery and weighed down the path of policy. Today, with headwinds shifting to tailwinds, the reverse could hold true.
Translation Conclusion: We’re bullish on the economy. Still, we’re not going to hike every meeting like we did under Greenspan.
Pay attention, though. Here’s the key takeaway for you, since I’m saying it last. “The macro environment today is the mirror image of the environment we confronted a couple of years ago”. That tells you I’m an economic bull. And since I used to be a dove that had to be convinced to raise rates, that’s important. I’m still cautious about the jobs picture. But now I a hawk.
This marks a change in Fed policy.