The Federal Reserve has released its semi-annual monetary policy report (https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf) and it indicates that policymakers remain upbeat on the economy’s prospects and that “gradual” interest rate hikes will continue. Perhaps the biggest surprise is the lack of discussion on trade protectionism and the message the flattening yield curve conveys with regards to the perceived threat of recession. It may well be that Governor Powell is saving his commentary on those topics for when he appears before Congress to testify on monetary policy next week.
The report described economic activity as expanding at a “solid pace” and acknowledges the rise in inflation, although argues that it has been “boosted by a sizeable increase in energy prices” - the fact that yesterday’s core CPI figure hit 2.3% and is above the Fed’s 2% target was not mentioned due to the cut-off date for publication. The strength of the jobs market was also highlighted, but wage growth was still merely described as “moderate”. Taking this altogether, they argue that this warrants “further gradual removal of monetary policy accommodation”.
The report sounded relaxed on financial conditions given they “have generally continued to support economic growth”, while “vulnerabilities from leverage in the financial sector remain low”.
In terms of trade, the only substantive commentary around it was within a paragraph looking at the balance of risks. The report noted that “shifts in trade policy or developments abroad could weigh on the expansion”, but that “U.S. fiscal policy could have larger or more persistent positive effects on real activity”.
In our view the high frequency data suggests that the US economy roughly grew at a 4% annualised rate in 2Q18, has headline inflation at near-enough 3% and a jobs market that is the strongest its been for the best part of 50 years. Certainly trade protectionism presents a risk, but the size of the tariff increases announced so far is dwarfed by the size of the tax cut given to households and corporates late last year. As such we continue to forecast two further rate hikes this year – one in 3Q and one in 4Q. We are likely to see a slower pace of policy tightening next year as higher borrowing costs and the uncertainty generated by trade worries (think more moderate capex and hiring) slow activity.
On a final point, the report also contains a number of special reports, one of which on oil acknowledged that the US economy is now far less vulnerable to energy price spikes given the growth in the domestic oil and gas sector, nonetheless, price hikes still have “important distribution effects”. They have another paper on “monetary policy rules”, which President Trump was reportedly considering making the Federal Reserve adhere too before announcing Powell’s appointment as Fed Chair. The Fed sound dismissive for obvious reasons, arguing “The use of such rules requires, among other considerations, careful judgments about the choice and measurement of the inputs into the rules such as estimates of the neutral interest rate, which are highly uncertain.”