The Fed steps up the pace of balance sheet reductions and interest-rate hikes in the second half of 2018.
The Fed meeting in June brought the expected rate hike and a mildly hawkish press conference. The June increase — the second this year — pushed the funds rate target to a range of 1.75% to 2.00%, and policymakers signaled they are on track to raise short-term rates at least twice more in 2018. We were a little surprised by the tone of the press conference. Fed Chair Jerome Powell described the state of the economy as “great” and the case for further rate hikes as “strong.” The problem with this more direct mode of communication is that it is deeply misleading. The current state of the economy is essentially irrelevant to the choice about policy. The economy’s position today reflects yesterday’s policies.
A more hawkish Fed?
There is tightening in the pipeline as the Fed steps up the pace of balance sheet reductions in the second half of the year, coupled with additional Treasury borrowings (debt issuance) as the deficit widens and the government rebuilds cash balances. Short-term rates have kept pace with balance sheet reductions. It’s not at all clear to us that the Fed is paying enough attention to these developments at the front end of the yield curve, which are certainly rippling through the economy and asset markets. This is not to say that the Fed is wrong to continue on the path of balance sheet reductions. Still, we think Powell was being a bit blasé in his recent comments.
The Fed’s assets are slightly below 22% of gross domestic product (GDP) from a peak of just over 25% of GDP in the third quarter of 2014. The Fed increased monthly balance sheet reductions in April 2018, in the July-September quarter, and it will reach $30 billion a month in Treasuries and $20 billion a month in agency securities in October. This is the pace at which it will level off.
Could the stance of policy become too tight? We do think this is the risk now. Private sector balance sheets show a large accumulation of debt obligations, and rising debt service costs raise default risks. Inflationary pressures will remain modest. However, headline inflation will continue to reflect developments in the commodities markets, including rising oil prices. The Fed isn’t too far from neutral now, and it has openly admitted it isn’t certain what the neutral rate is, and how it may be changing. Several recent FOMC speakers have argued that a key reason for moving slowly on policy is to reduce the risk of doing too much when there’s so much uncertainty. But while the approach may well lower the risk of overtightening, it doesn’t eliminate it. An extra dose of caution would be appropriate at this stage of the cycle, rather than the exuberance about the “great” state of the economy that we got at the last Fed press conference.
U.S. growth is expected to be a bit better in the second half of the year compared with the first half. The economy grew at an annual rate of 2.2% in the first quarter of 2018 due to weak consumer and business spending. Growth was below the 2.9% annualized rate in the fourth quarter of 2017. While it certainly seems Q2 will be a lot stronger than Q1, we shouldn’t get carried away. The U.S. economy has expanded a little above 2% over the past few years. The latest fiscal stimulus and the rise in corporate investment will push growth higher.
There were positive and negative surprises in recent economic data. While manufacturing looked good, concerns are rising among manufacturers about trade issues, and regional activity indicators were mixed. The non-manufacturing sector is doing quite well, but consumption was sluggish. Spending growth remains quite subdued and has not picked up as much as many analysts expected.
In addition, the savings rate is starting to rise after the sharp decline in 2016 and 2017. If this continues, it will be hard for consumption growth to accelerate meaningfully. Household debt has been rising quite quickly, and housing is sluggish with no real momentum. So, while we acknowledge that Q2 was better than Q1, and while we continue to think H2 will be a bit better, if the trade war fears are not realized, the improvement as measured numerically will not be especially large.