Low inflation and a moderate deceleration in economic growth may prompt the Fed to pause on future rate increases.

Federal Reserve policy makers are closely watching the unfolding interplay between growth, inflation, wages, and other economic indicators to manage interest rates. The U.S. economy slowed at the end of 2018. Gross domestic product — the broadest measure of goods and services produced in the country — grew at a 2.6% annual rate in the final three months of last year. Consumer spending, the bedrock of the economy, increased, exports rebounded, and businesses stepped up their investments.

In addition, the U.S. services sector, as measured by the Institute for Supply Management’s (ISM) non-manufacturing purchasing managers index, expanded at a faster rate in February. If the sector’s rebound becomes a pattern, then hawks at the Fed will start to spread their wings. There will be talk about another interest-rate hike. However, we believe that higher rates — either by the Fed raising short-term rates or the markets pushing longer-term rates up — will be harmful to risky assets and the economic outlook. Conversely, a set of weaker data will likely push interest rates lower, creating some stimulus for the economy.

Winners and losers in the labor market

The labor market remains strong despite the slowdown in job creation in February, which is allowing household income and spending to grow. It is all happening at a steady pace, consistent with GDP growth of about 2%. Although hiring slowed last month, wages are edging up, the economy is inching toward full employment, and there are some signs of a cyclical top. However, the pace of job creation slowed because of rising labor costs. With inflation contained by global factors, employers can’t pay higher wages and pass the higher costs on in the form of higher prices. So, they resist higher wages when they can, and they reduce employment growth where they cannot.

Changing minds?

We doubt the February jobs report (20,000 new jobs) will change any minds at the Fed. The FOMC has made it clear it pays attention to price, rather than wage, inflation. Even with accelerated wage gains, it’s not clear how, or how quickly, this would translate into higher consumer price inflation. It could simply result in slower job creation. The economy is still adjusting to reduced fiscal stimulus and the lagged effects of 2018’s interest-rate increases.

Inflation expected to hold steady (% year-on-year)

We’ve heard quite a lot from the Fed recently. Officials have sought to clarify their views on the outlook for the economy and interest rates. Richard Clarida, the vice chair of the Fed’s Board of Governors, is stressing the importance of low inflation in permitting the Fed to be patient about its next rate move. If the labor market remains strong, the Phillips curve warriors at the Fed will start to get nervous and talk of another hike will resurface. With the yield curve so flat, an interest-rate increase would be very damaging to risky assets. But should the yield curve steepen because of rising inflation expectations, it would be a different story.

Balance sheet plans

Fed Chair Jerome Powell has announced a plan to stop shrinking the estimated $4 trillion balance sheet that was built up during the 2008 financial crisis. The balance sheet was stable at about 6% of GDP before the crisis. It peaked at about 25% of GDP post-crisis, and it is now below 20% of GDP. Powell was clearly trying to avoid being too specific, but he hinted at a GDP level of 16% to 17% for the Fed’s balance sheet. This is a fairly wide range, and the time span needed to reach that level matters to markets and investors. Perhaps the key point is that the Fed’s balance sheet is going to remain large, keeping the central bank at the heart of asset markets for the foreseeable future.

If the Fed were to raise interest rates this year, it will be in a context of stronger economic performance.

In addition, there has been some focus on possible changes to the Fed’s strategy. The key issue: With a low and perhaps permanently neutral interest rate, it is likely the Fed will be constrained by the zero-nominal bound on interest rates in a future downturn. What should the Fed do about this? Academics have favored price-level targeting, but the Fed views this as too complicated to explain to the public. The idea that seems to be gaining popularity is “average inflation” targeting. That would enable the Fed to make up past inflation undershoots (or overshoots). Under the current system, the target is reset every year. But we are a long way from this being possible.

The Fed continues to talk about being patient on the direction of interest rates. The overall tone is dovish. If the Fed were to raise interest rates this year, it will be in a context of stronger economic performance.

Next: China’s growth playbook

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The global economy continues to slow. Higher interest rates, weaker demand from China, political troubles in the eurozone, and protectionist tariffs have kept the lid on economic growth.