By Karl W. Smith / BloombergFed Gov. Lael Brainard gave a speech Tuesday night entitled, “Navigating Monetary Policy as Headwinds Shift to Tailwinds.” She noted that the U.S. economy was beginning to benefit from major tailwinds. Federal budget cuts, which had previously subtracted from growth, were replaced by tax cuts that add to it. Growth in Europe and Asia was picking up and with that would come more demand for U.S. exports.
That same evening, Gary Cohn, director of the National Economic Council, resigned after failing to dissuade U.S. President Donald Trump from imposing tariffs on steel and aluminum. The resignation was widely seen as bolstering the fortunes of protectionists in the White House such as trade adviser Peter Navarro and Commerce Secretary Wilbur Ross.
Markets opened lower around the world on the news. Commodities were lower and interest rates declined. All signs pointed to rising fears of global trade wars and new headwinds that would slow growth.
Fortunately, the heart of Brainard’s guidance was general enough to be useful no matter what happens. Wall Street is used to viewing a positive economic outlook from U.S. Federal Reserve officials as a sign that interest rates will soon be rising. Indeed, I think many people mistakenly perceived that to be the message of Chairman Jerome Powell’s initial testimony before Congress last week.
The Fed is trying to communicate something more subtle, however, and Brainard’s speech was a good example. The Fed’s preferred measure of inflation, the core price index for personal consumption expenditures, has been running well below target since the 2008 recession. Despite this, the Fed has begun a campaign of slowly raising interest rates.
Fed officials have defended these moves by noting that the low readings on inflation were driven primarily by transitory factors that they expect to diminish over time. Consequently, market participants should not expect the Fed to give up its long term plans simply because inflation was unexpectedly and temporarily low.
In the past, I and a lot of other commentators interpreted this view as an indication that Fed officials were most intent on controlling inflation. By that thinking, the mere specter of inflation rising above the Fed’s 2 percent target would be enough for them to raise interest rates to cool growth.
Brainard’s speech was the clearest repudiation of this view so far.
Although experience in other countries suggests it can prove difficult to raise an underlying inflation trend that has been running below policymakers’ target for several years, stronger tailwinds may help re-anchor inflation expectations at the symmetric 2 percent objective. Of course, it is conceivable we could see a mild, temporary overshoot of the inflation target over the medium term. If such a mild, temporary overshoot were to occur, it would likely be consistent with the symmetry of the FOMC’s target and could help nudge underlying inflation back to our target.
In other words, 2 percent inflation shouldn’t be thought of as an upper limit, just a rough target. Overshooting it would be consistent with the Fed’s goals. Not only that, she goes on to hint that the Fed might actually like to see an overshoot.
Recent research has highlighted the downside risks to inflation and to longer-run inflation expectations that are posed by the effective lower bound on nominal interest rates, and it suggests the importance of ensuring underlying inflation does not slip below target in today’s new normal.
That’s an argument that the conventional view that 2 percent inflation is an upper limit is not only incorrect, but dangerous.
My takeaway is that markets should not interpret talk of a strong economy as a signal that the Fed is necessarily going to raise interest rates. As long as the Fed views the inflationary effects as transitory, as the stimulus from the recent tax cut is likely to be, a steady-as-she-goes approach is the Fed’s baseline response.
What then to make of a potential trade war? Apply the same logic: If higher tariffs are a temporary policy that is likely to be reversed as the president renegotiates trade agreements, then we should expect the Fed to stand pat, even if that means absorbing a short-term hit to growth.
On the other hand, if what we are seeing is really a shift in U.S. trade policy, then the Fed is likely to take that into account and seek to offset some of the loss of growth. Which would mean a slower rise in interest rates.