U.S. economic strength may help the Fed make the case for taking two steps forward on the policy-tightening path.

Our sense is that the Fed is becoming more confident in the growth outlook and that discussions about the relative roles of rate hikes and balance sheet contraction are a bit more advanced than we had thought. At its early May meeting, the Fed dismissed the weakness of Q1 data (“The Committee views the slowing in growth in the first quarter as likely to be transitory”) and is optimistic about consumption growth in the coming months (“The fundamentals underpinning the continued growth of consumption remained solid”). Thus, most Federal Open Market Committee (FOMC) members seem to expect a rate hike in June. Or, to put it another way, it would take something unexpected to forestall a June hike.

It’s also looking quite likely that we’ll see some (small) moves on the Fed’s balance sheet before the end of year. But if there is to be balance-sheet reduction in December, the policy has to be communicated to markets beforehand — probably by October at the latest. That means the Fed must be close to agreement now. A more confident Fed engaged in balance-sheet reduction, combined with an executive branch that is fixated on setting various forms of stimulus in motion, may establish some interesting dynamics for 2018. We could have fiscal stimulus in an economy that is at full employment even as the Fed is tightening and is likely to be in transition to new membership and new leadership.

The end of the expansion?

The current expansion in the United States is already one of the longest on record. While we are not fans of the numerological approach to the business cycle (the average cycle, peak to peak, is x months; the average peak to trough is y months; the next recession is some imaginative function of x and y), it is true that expansions do not go on forever. That doesn’t mean they always die of old age, of course. Recessions can be sparked by shocks and by policy mistakes, and can be triggered by imbalances that emerge in periods of exuberance. And while there is always a risk of a policy mistake, that risk is greater at some points in a cycle; or rather, there are times when setting the right policy is much harder to do.

A more confident Fed engaged in balance-sheet reduction, combined with an executive branch that is fixated on setting various forms of stimulus in motion, may establish some interesting dynamics for 2018.

It is becoming clearer to us that 2018 is likely to be one of those times. It is a plausible story that the economy is growing at an above-trend pace and is at, or is close to, full employment. These are the conditions under which imbalances can grow. It is also an environment in which corporate margins could come under pressure as wages and employment costs rise. Unsurprisingly, companies would probably react to wage inflation by raising prices to protect their margins. Consequently, policy ought to be looking to slow the economy to prevent the emergence of imbalances. But if 2018 brings a fiscal expansion and untested Fed leadership, the potential imbalances could be worse, and recession risks could begin to rise materially.


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