When the Federal Reserve lifted interest rates by a quarter point on Wednesday, its first policy decision on new chair Jay Powell’s watch surprised nobody. Everyone had expected the rise, and everyone had largely expected Powell to stay the course the Fed’s monetary policymakers had carefully staked out.
Much like Sherlock Holmes’s dog that didn’t bark, it is the lack of change that should be seen as surprising. Since the Fed’s December meeting, the US government has enacted not just one, but two highly stimulative acts of fiscal legislation. The December tax reform created a fiscal stimulus worth 0.7 per cent of gross domestic product in both 2018 and 2019, calculated as the additional increase in the (non-interest-related) deficit caused by the legislation, according to the Congressional Budget Office. On top comes the new spending authorisation passed in February.
This is a big and sudden fiscal stimulus. It was far from clear in December what form it would take or how stimulative it would be. The fact that Fed policy has hardly changed is therefore a puzzle in need of an explanation. As the chart below shows, the median projection of Fed policymakers for the policy rate in 2018 did not change at all; those for the end of 2019 and 2020 nudged up a notch. That’s long after the fiscal stimulus hits the economy — “ahead of the curve” this is not.
And it’s not as if the Fed doesn’t think the economy will respond. Its projections of growth and unemployment have both improved markedly. Meanwhile, as John Authers highlights, the Fed’s inflation prediction also remains unchanged, “despite more bullish predictions for both employment and economic growth”.
How to explain that a monetary policy deemed appropriate four months ago is still seen as such after these big changes? One answer could be that the Fed thinks its marginally tighter policy path is enough to counterbalance the fiscal stimulus (even if the median projection didn’t change much, many individual interest rate-setters tightened their forecast). But Powell himself went out of his way in his testimony to make people focus only on the March decision, not on the future path. And according to the Fed’s own projections for the real economy, its policy will not in fact undo the expansionary effects added since December.
It could instead be that the Fed thinks the fiscal changes will improve the economy’s capacity to grow by as much as actual growth — thus removing the need for compensatory tightening at the hands of the central bank. Powell made nods to the incentives for investment and greater labour participation due to lower tax rates. But they were no more than nods, and in any case this speculation is too uncertain to base monetary policy on.
A better-founded view is that the US economy is still well below its full-employment capacity — as suggested by the prime-age employment rate, which is still below its 2000 peak, if not by the ultra-low unemployment rate. If so, there is no need for the Fed to tighten just because fiscal policy adds a strong boost to demand; it is welcome that fiscal policy accelerates the economy’s catch-up with its potential. But the inconvenient truth implied by that is that before the fiscal stimulus was enacted, the Fed’s policy was significantly too tight.
In the immediate term, meanwhile, the economy has actually come to seem less rather than more buoyant. The Fed’s own statement made one significant change to its assessment of the economy — labelling household spending and investment growth rates “moderate” rather than “solid”, as it did in January. And the Atlanta Fed’s real-time tracker of economic data suggests GDP has slowed to a crawl, with an estimated contemporaneous annualised growth rate of 1.8 per cent, down from a (admittedly completely unsustainable) 5.4 spike at the start of February.
That suggests other forces may be chilling aggregate demand just as government spending and tax cuts are about to stimulate it. If so, holding fire is an even more appropriate monetary response. Much of the market reaction suggests that investors expect the central bank to have to pull back even further. Futures markets pricing implies less tightening than pencilled in by the Fed, and the dollar dropped after the Wednesday statement.
The Fed has been wrong on monetary policy twice before since the crisis. It consistently over-predicted its own ability to start a tightening cycle, while markets rightly thought rates would stay lower for longer. And, as I have argued here, if the current policy stance is correct, then it was far too tight until very recently. We should not rule out a third mistake: that capacity is greater and demand will be weaker than the Fed now foresees. If so, even the present course may prove uncomfortably tight.
