AUG Market Update 2019 The Fed Gets It Right ... for the Right Reason? Ronald Temple, CFA, Managing Director, Co-Head of Multi-Asset and Head of US Equity David Alcaly, CFA, Research Analyst On 31 July, the Federal Open Market Committee (FOMC) cut its target for the federal funds rate by 25 basis points (bps), com- pleting an about-face that began last year. Over the past seven months, the FOMC has moved from hiking rates, to remaining “patient,” to acting “as appropriate to sustain the expansion,” despite limited evidence of unexpected economic weakness. At the same time, the Federal Reserve has launched a review of its strategy, tools, and communications, focused in large part on the chal- lenges low interest rates, low growth, and low inflation pose for monetary policy. We believe that the FOMC has made the right decision in reducing rates. As we have long argued, the case for hiking rates aggres- sively last year was weak and there are clear benefits to running a “high pressure economy.” Furthermore, the risks surrounding inflation remain to the downside—core PCE inflation has hit the target of 2% in just 6 of the past 86 months. The combination of the FOMC’s pivot in short-term policy with the broader review of how the Fed makes policy more generally suggests that the Committee might have come around to this point of view and narrowly averted a policy mistake. We recognize that unpredictable trade policy could change the economic environment. That said, while there are some pockets of weakness, we believe the US outlook remains solid and has not changed dramatically since December. Current conditions suggest that a reasonable argument can be made for a few “insurance cuts,” but not a full easing cycle. We believe the FOMC should support con- tinued growth to secure the continued benefits from tight labor markets and to aspire to a period of above-target inflation, in keeping with the theoretical “symmetry” in its inflation target. However, despite an emphasis on transparency, the FOMC has had a lot of trouble explaining its pivot. Both at the beginning and at the end it has had to walk back statements that were misinterpreted by markets. We expect continued market uncertainty about the number of rate cuts ahead, with investors focused on the Fed’s busy speaking schedule. We hope that the results of the Fed’s review—expected in early 2020—add clarity by demonstrating that the Fed is adopting a new policy framework with more emphasis on supporting maximum employment and raising inflation, rather than containing it. We also would advocate a new communications framework focused on higher quality, rather than higher frequency, communications. The Right Decision ... We have long believed the argument for aggressive rate hikes was weak, and that the FOMC ought to want to realize above-target inflation on a sustained basis before tightening policy. Our view is mainly based on three factors: 1) the expansion has been weak; 2) there are significant labor market benefits from allowing the economy to “run hot;” and 3) there is little risk of undesirably high inflation. First, the recovery from the global financial crisis has been slow and weak. The actions taken by the Fed limited the financial crisis’s severity and contributed to what is now the longest US expansion since at least the 1850s. Fiscal stimulus also helped initially, but was too small and was withdrawn too quickly. However, growth in both real GDP per working age population and in total nonfarm payroll employment has been slower this expansion than in all other postwar expansions, with the exception of the pre-crisis expan- sion—itself a disappointment. As a result, estimates of both the level and the growth rate of potential output are lower today than they were before the crisis. For example, the Congressional Budget Office (CBO) estimate of potential US real GDP is more than 10% below its pre-crisis estimate LR32041 2 (Exhibit 1). This implies that more should have been done to support growth and that doing too little may have reduced future growth and Exhibit 1 Estimates of Potential Output Have Been Heavily Cut economic well-being, through foregone investment, sustained under- US Real GDP employment, and depressed labor force participation. (1Q 2001=100) Second, there have been clear labor market benefits from running what 160 Janet Yellen called a “high pressure economy,”1 reversing some of these effects. A range of measures suggest that much of the potential work- 140 force was slow to benefit from the recovery, but has since experienced improved prospects as the unemployment rate has fallen to its lowest 120 level in nearly five decades. For example, a large number of people withdrew from the labor force entirely following the crisis, a dynamic 100 not captured by the unemployment rate, which only measures individu- 80 als actively looking for work. While separating cyclical trends from 2001 2004 2007 2010 2013 2016 2019E 2022E structural trends is complicated, the share of prime age (25–54) adults in US Real GDP CBO Estimate of Potential Real GDP, Jan 2007* the labor force bottomed in 2014 for men and in 2015 for women. The CBO Estimate of Potential Real GDP, Jan 2019 decline since has returned 0.6 million men and 1.3 million women to As of March 2019 the labor force (Exhibit 2). Similarly, the share of prime age adults not * Original value in chained 2000 US dollars. Adjusted based on 1Q 2000 output gap. in the labor force due to illness or disability rose by over a percentage Source: Bureau of Economic Analysis, Congressional Budget Office, Haver Analytics point from 2001 to 2014, but has since declined.2 The FOMC’s economic projections demonstrate an evolving understanding that tight labor markets are more sustainable than Exhibit 2 previously thought. The lowest FOMC projection of the longer-run Tighter Labor Markets Are Drawing People Back into the Workforce unemployment rate increased from 4.5% in January 2009 to 5.2% Labor Force Participation Rate in late 2013 and early 2014, before many of the benefits of tighter labor markets were realized. Since then, the median FOMC projec- (Pre-Crisis Peak =100) 101 tion of the longer-run unemployment rate has declined to 4.2% and the lowest FOMC projection has fallen to 3.6%. At his 31 July 2019 100 press conference, Chair Jerome Powell explicitly acknowledged the Female, Age 25–54 benefits tight labor markets were having: 99 Wages have been rising, particularly for lower-paying jobs. People who live and work in low- and middle-income 98 communities tell us that many who have struggled to find work are now getting opportunities to add new and better chapters to their lives. This underscores for us the importance 97 of sustaining the expansion so that the strong job market Male, Age 25–54 reaches more of those left behind.3 96 2007 2009 2011 2013 2015 2017 2019 Third, we believe the risks surrounding inflation are clearly to the As of July 2019 downside. The experience of the “Great Inflation” of the late 1960s– Source: Bureau of Labor Statistics, Haver Analytics early 1980s has biased Fed policy toward “getting ahead of the curve” based on the idea that being too tolerant of tight labor markets could lead to rapidly accelerating inflation, forcing drastic rate hikes that subsequently cause a recession. These risks are very low today. The Exhibit 3 Great Inflation took time to develop and occurred under far different Core PCE Inflation Last Hit 3% in 1992 circumstances. The last time core PCE inflation was as high as 3% was Personal Consumption Expenditures Less Food and Energy in 1992, during its decline from that episode (Exhibit 3). This cycle, YoY Change (%) 12 core PCE has only hit the Fed’s target of 2% in six months since April 2012, all in mid-2018. It has since moved in the wrong direction, fall- ing to 1.6% even as labor markets tightened further. Furthermore, the 9 slow recovery in the United States, as well as even slower growth and weaker inflation in other advanced economies, strongly suggests that 6 inflation pressures are weak globally. There also is every reason to believe that the Fed could easily con- 3 tain inflation if necessary. Inflation has been relatively insensitive to changes in the unemployment rate in recent decades. It is highly 0 unlikely that it will accelerate uncontrollably, much less that this 1969 1979 1989 1999 2009 2019 would happen suddenly and from such a low level. Interest rates As of June 2019 remain very low, suggesting that small rate hikes could slow activity. Source: Bureau of Economic Analysis, Haver Analytics And the Fed has an unlimited ability to tighten policy. The much 3 more worrisome future constraint is its limited ability to cut rates and implement other unconventional policies in a recession, a limitation Exhibit 4 Markets Were More Dovish than the FOMC that is exacerbated by persistently low inflation. Projected Fed Funds Rate All of these points suggest the FOMC should maintain easy policy (%) even as labor markets continue to tighten, at least until above-target 3 inflation is realized on a sustained basis. In fact, rather than seeking to “get ahead of the curve,” the FOMC should want to see higher infla- tion. This idea is implicit in some of the monetary policy strategies 2 currently under the Fed’s review, such as average inflation targeting or price level targeting. We hope the FOMC’s pivot in short-term policy, combined with the broader review of how the Fed makes policy, 1 reflects that the Committee has come around to this point of view Jan 18 Jul 18 Jan 19 Jul 19 Jan 20 Jul 20 while avoiding a policy mistake.