When boring is good

Principal Economist's View

 
Many pundits often criticise economists as being boring. But sometimes, boring is exactly what you need. Especially when there is an element of chaos brewing a mile down the road in Washington.  

This week, the US Federal Reserve (Fed) decided to raise the federal funds target range by 25 basis points to 2.0%-2.25%. Such a move was universally expected by financial markets and triggered minimal market reaction. One could say the event was boring. But when the goal is to keep the economy on an even keel, the Fed’s measured approach to monetary policy is a welcome development. After all, the US economy is in good shape; growth is strong, unemployment is low and inflation is close to their target. The Fed’s job is to do everything in their power to keep it this way.  

The few changes that the Fed made at this meeting were downplayed. Dropping the reference to policy being ‘accommodative’ was emphasised in the press conference as not indicating any change in the path of policy, with Chair Powell highlighting that policy is in fact sill accommodative. Rather, in our view, it was a deft approach to tweak the statement sooner rather than later, with the longer the Fed left the shift in language, the more likely the market could overreact to the change. The updated projections by the Fed also contained only minor changes, with the economy evolving broadly in-line with the Fed’s expectations.

Overall, the Fed remains optimistic on the outlook. Real GDP is forecast to expand by 3.1% in 2018, before gradually easing to an above-trend 2.5% in 2019 and 2.0% in 2020 before settling at its longer-run rate of 1.8% in 2021. Core PCE inflation is forecast to remain around 2% over the remainder of 2018, before edging up to 2.1% over the next three years, only modestly above target. The unemployment rate is forecast to continue to edge lower, dropping to 3.7% by the end of 2018 and 3.5% in 2019 and 2020, before edging higher to 3.7% in 2021. 

To keep inflation in check, and to prevent overheating in the economy, the Fed expects to continue to gradually lift rates over the next few years. In particular, the median expectation of FOMC members is to lift rates again in the December quarter, followed by three more hikes in 2019 and another hike in 2020. This would push rates to 3.4% by the end of 2020, where they would remain throughout 2021. In the Fed’s view, this would push monetary policy into slightly restrictive territory; modestly above the Fed’s longer-run federal funds rate view of 3.0%.

In terms of the trade conflict with China, Chair Powell downplayed the impacts. He suggested that the impact of the tariffs that have been announced will be “relatively small.” Nonetheless, he did highlight that “if this perhaps inadvertently goes to a place where we have widespread tariffs that remain in place for a long time for a more protectionist world, that's going to be bad for the United States' economy, and for American workers, and families, and also for other economies.” 

Chair Powell has also tried to emphasise the inherent uncertainty around the medium-term outlook for the economy. Reflecting his view of these uncertainties, Chair Powell continues to advocate a pragmatic approach to monetary policy, whereby the Fed will assess incoming economic and market data at each meeting to determine the appropriate course to monetary policy. The impression one is left with is that the Fed’s approach to policy will become much more data dependent in 2019 and 2020.    

How does the Fed’s view compare to ours? In a broad sense, we share a similar view to the Fed, with robust economic performance likely to continue over the next few years. However, we are a touch less optimistic, expecting growth to slow to around 2.1% by the end of 2019 and the unemployment rate to trough at around 3.7%. Consequently, we expect a more gradual path of rate hikes, with one less hike expected by the Fed next year. As a result, we expect rates to reach 3%-3.25% by the end of 2021, about 25bps below the Fed’s expectation, but around 25 basis points above current market pricing.    

After years of unconventional monetary policy, a gradual and measured approach to higher policy rates in the US should not be viewed as boring. Rather it is crucial to ensuring the longevity of the global economic expansion currently underway.  

Table 1: Financial market movements, 20 – 27 September 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,914.0

-0.6%

US

3.05%

-1.1 bps

US Dollar Index (DXY)

94.89

1.0%

Nikkei 225

23,796.7

0.5%

Japan

0.12%

-0.3 bps

USD-JPY

113.38

0.8%

FTSE 100

7,545.4

2.4%

UK

1.60%

1.3 bps

GBP-USD

1.308

-1.4%

DAX

12,435.6

0.9%

Germany

0.53%

5.8 bps

EUR-USD

1.164

-1.2%

S&P/ASX 200

6,181.2

0.2%

Australia

2.69%

-2.7 bps

AUD-USD

0.721

-1.2%

Source: Bloomberg

 

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