Heed the Data, Not What Fed Officials Say
Is Federal Reserve Chairman Jerome Powell a dove or a hawk on inflation? Most likely, he is neither. Instead, he’s data dependent. That’s important because all Fed senior officials are being pushed by the economic data in the direction of more or faster interest-rate increases. Investors are catching on, with the market starting to price in four rate hikes this year.
Answering questions by lawmakers about the state of the economy three weeks ago, Powell largely relied on the data. He avoided projecting outcomes, even if they seemed logical. When asked whether there was still room for people outside the workforce to be drawn in and enable hiring to continue at a pace that is above trend, Powell was willing to accept that labor-force participation for prime-aged adults was still low at 63 percent. He was careful, though, to avoid predicting whether more individuals might rejoin the job market.
Powell also acknowledged that growth had improved, but didn’t suggest the economy was overheating. His remarks also implied that he was inclined to wait to see if inflation pressures become manifest in the form of accelerating labor costs and higher price inflation.
But when even an established dove such as Federal Reserve Bank of Minneapolis President Neel Kashkari, who has dissented often against rate hikes, acknowledges that growth has picked up significantly, it is easy to determine that Fed officials are moving toward more increases. That said, the pace matters, and that requires more data on how the economy is evolving.
The Fed has consistently overestimated real economic growth, while underestimating the drop in unemployment. It is very difficult to reconcile faster growth with slower declines in unemployment. This may explain why some officials hope that those outside the labor force will re-enter or productivity will accelerate. The Fed’s Statement of Economic Projections, which will released after the Federal Open Market Committee meeting, will be useful in understanding how policy makers choose to modify their unrealistic forecasts.
The Fed has gotten precisely this outcome, as the lack of electricity and jobs in Puerto Rico has driven many to venture to the U.S. mainland to find work. This has boosted labor force participation and employment, and the trend may continue for a few more months. Barring further fortuitous developments, faster growth and falling unemployment would imply that inflation is poised to accelerate. The Fed is clearly discussing this possibility internally in terms of how policy should evolve in the absence of additional labor force participation or faster productivity.
The doves wouldn’t mind allowing inflation to rise to about the Fed’s 2 percent target, with the justification being that policy makers should show that the target is symmetrical or to make up for some years when inflation was below target. The hawks worry that it would be difficult to stuff the inflation genie back into the bottle once it emerges. In the end, the theoretical models of economists must be reconciled with the data. While declining unemployment clearly points to faster inflation, theory is incapable of providing insight into the timing.
So, is Powell an inflation hawk, as many concluded after he seemed three weeks ago to be moving toward supporting a fourth rate in 2018? The better question is, will the data continue to show an ever-tightening labor market, with all of the consequences of such a development? If it does, expect Powell and his colleagues to increase rates more aggressively than the three hikes currently on the drawing board for this year. But if growth moderates and unemployment stops falling, the Fed could choose to hike only twice. That path seems increasingly implausible given tax reform and the proposed infrastructure spending.
Publicly, Powell has provided no guidance on how this will play out. He’ll just let the data do all the talking. I’m betting on at least four rate hikes in 2018.
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