US Fed in Transition Doesn’t Rock the Boat

No discussion of tax cuts as economy shows more signs of strengthening

U.S. Federal Reserve Board Chair Janet Yellen in her final interest rate decision press conference in Washington, D.C., on Dec. 13, 2017. (Brendan Smialkowski/AFP/Getty Images)

The U.S. Federal Reserve left its key policy rate range unchanged at 1.25 percent to 1.50 percent on Jan. 31, as was widely expected.

The January Fed meeting, the last one with Janet Yellen as chair, was expected to be uneventful; however, the market is nearly certain of a 0.25 percent rate hike for March’s meeting—Jerome Powell’s first as Fed chairman.

The U.S. economy is strong enough to absorb more rate hikes, based on the Fed’s latest assessment. What the U.S. central bank did not reference in its statement, however, was the significant tax reform enacted in December, which adds further impetus to the economy.

Kathy Bostjancic, chief market economist at Oxford Economics in New York, said the Fed could have addressed the tax cuts. “I think it was probably calculated that it was better not to mention fiscal policy,” she said in a phone interview.

While the Fed could still be trying to assess what the impact on the economy will be, Bostjancic added that if the Fed discussed the tax cuts, “It could be misconstrued by the market that they’re trying to send a signal and that may be misinterpreted as being more hawkish as a policy statement than they wanted to convey.”

Financial markets are no longer discounting the Fed’s willingness to raise rates by pricing in fewer rate hikes than its most recent projections. The U.S. central bank’s December projections have three rate hikes penciled in for 2018. Bostjancic said shortly after the Fed statement was released, that markets are pricing in a 65 percent chance of three rate hikes and a 28 percent chance of four increases this year.

The fly in the ointment for some time has been inflation, which is still slightly below the 2 percent target, but Bostjancic says the Fed’s upgrade of its assessment of inflation is the most important part of the Jan. 31 statement.

For years the Fed has been saying it expects inflation to reach the 2 percent target in the medium term and finally the market is a believer.

“Inflation on a 12-month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective,” according to the Fed statement. This is an upgrade over December’s language that said inflation was expected to “remain somewhat below 2 percent in the near term.”

Weak Greenback, Higher Future Inflation

It’s not an easy answer as to why the U.S. currency has depreciated so noticeably in January. Factors that should support a strong dollar include the U.S. economy growing at the above-potential rate of 2.6 percent in the fourth quarter after half a year of 3 percent growth and the Fed raising rates faster than any other major central bank.

But Europe is looking like a bright spot now as well, rebounding off a low base. “On the margin, Europe is actually growing faster than was expected,” Bostjancic said.

And while the tax cuts are expected to give a nudge to U.S. growth, markets may be shifting their attention from higher interest rates in the United States versus Europe to the significant amount of deficit financing needed to fund the U.S. tax cuts. The twin deficits—trade and budget—are factors that weigh on the greenback.

But as it relates to monetary policy, at some point, the greenback’s being at its lowest in three years is going to contribute to higher future inflation.

The challenge for the Powell-led Fed is conducting monetary policy in the face of massive fiscal stimulus when the economy is at full employment and seeing above-potential economic growth.

Yellen was known for her dovish monetary policy and Powell has indicated he intends to continue in her footsteps.

The rubber meets the road in March for Powell’s first meeting as Fed chairman. Markets are giving the Fed the green light to raise rates.

“Any pause in tightening risks falling behind the curve at a time when tax cuts are set to push the economy into excess demand and risk stoking inflation,” said RBC economist Josh Nye in a note.

By March, the Fed will have more time to assess the effects of the tax cuts and will publish updated economic projections and forecast future interest rate hikes.

Follow Rahul on Twitter @RV_ETBiz