Federal Reserve Chairman Jerome Powell’s speech on 28 November helped stir a market rally as investors interpreted his comments as more dovish and favorable to risk assets. However, to extrapolate his comments into a belief that the Fed is preparing to pause its rate-hike cycle after one more hike in December is still premature, in our view, given the outlook for slowing but still above-trend U.S. growth in 2019.
Two passages in Powell’s speech garnered significant attention. The first addressed the neutral interest rate:
“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.”
This was a departure from Powell’s comment in early October that we are “a long way from neutral.” However, it was similar to comments from Vice Chair Richard Clarida during a CNBC interview two weeks ago. And it likely doesn’t reflect a fundamental change in Powell’s views, but rather a shift from discussing his own long-term estimate for the neutral target fed funds rate, which we believe could be 3%, to the Federal Open Market Committee’s (FOMC) estimate, which is a “broad range” of 2.5%–3.5%, according to the latest Summary of Economic Projections (also known as the dot plot).
Monetary policy: looking forward?
The second comment may be more noteworthy, as it provided markets with further confirmation that Powell is focused on the pitfalls of hawkish policy mistakes:
“We also know that the economic effects of our gradual rate increases are uncertain, and may take a year or more to be fully realized.”
Powell was discussing the long and variable lags of monetary policy, which we have argued generally call for more caution as interest rates approach the estimated neutral range. Previous Fed Chairs Janet Yellen and Ben Bernanke cited these lags, but up until this speech, Powell had not specifically mentioned them. Rather, he cited the uncertainty around forward-looking model-based estimates of potential employment and neutral interest rates as a reason to focus on incoming economic data.
Earlier this year, we raised the question of whether a more backward-looking monetary policy framework posed a greater risk of a policy mistake. Hence, Powell’s speech this week was an important confirmation of the pitfalls of relying too much on reported data, and too little on forward-looking forecasts. Against this, it’s not surprising that markets also repriced the risk of a hawkish mistake.
While Powell’s speech may have provided markets with confirmation that central bankers are focused on the risk of overtightening policy and ending the cycle prematurely, we would not over-extrapolate Powell’s comments to suggest that central bankers are no longer focused on the risk that the economy overheats.
At the Jackson Hole Symposium, Powell referenced a paper (“Some Implications of Uncertainty and Misperception for Monetary Policy”) by Federal Reserve Board staff that finds that despite uncertainty around estimates of structural aspects of the U.S. economy, including the unemployment gap (the level of labor market slack), central bankers should not ignore these estimates. Indeed, the authors find that a “notable response to the unemployment gap is typically beneficial, even if that gap is mismeasured,” suggesting raising rates into restrictive territory might be necessary. The minutes from the November Fed meeting, after noting that “monetary policy was not on a preset course,” also highlighted “tightness in labor markets and possible inflationary pressures.”
After weighing the various monetary policy risks, we continue to expect the Fed will hike three more times between now and the end of 2019. While it is very likely U.S. growth will slow next year, it should remain above-trend, and continue pressuring the unemployment rate lower. Furthermore, although the recent tightening in financial conditions presents additional downside risks to the real growth outlook, we continue to believe recession risks are low over the cyclical horizon, as strong U.S. household balance sheets and a well-capitalized banking sector will be an important buffer against negative economic shocks.
The Fed outlook will be a theme at PIMCO’s upcoming quarterly Cyclical Forum, where investment professionals from the firm’s global offices gather to debate and formulate our high-level outlook for the economy and markets. We will publish that outlook, including updated forecasts for growth and inflation for major economies, in mid-December.
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