17 October 2017
Despite another downside surprise to core CPI inflation in September, Federal Open Market Committee (FOMC) members appear committed to a strategy of gradually normalising both the Federal Reserve’s (Fed’s) balance sheet and policy rates. The continuation of above-trend growth, declining slack in the labour market, and steady increases in the price of risky assets are the more important drivers of policy, unless officials begin to lose confidence that they will be able to meet their inflation objectives over the medium-term. As a consequence, we are sticking with our call that the Fed will lift the target range for the federal funds rate by another 25 basis points in December. Although we are concerned that the Fed’s current policy strategy may eventually undermine the credibility of its inflation target, we are more sanguine about the ability of the real economy and financial markets to absorb the reduction in policy accommodation. Even as the Fed has delivered a more aggressive path for rate hikes and balance sheet reduction than expected at the beginning of the year, neither the economy nor risk assets have skipped a beat. Indeed, the economy is so robust at the moment that hurricanes Harvey and Irma do not appear to have been enough to knock the economy even temporarily off course, with our tracking estimates for third-quarter growth remaining well above 2%.
Still, it does not pay to be complacent. As such, there is a panel of economic and financial indicators that we are monitoring very carefully for indications that a policy mistake is brewing and that the Fed will be forced to abandon any additional rate increases in 2018. Beginning with the labour market, temporary help employment peaked at least a year before each of the past two recessions, while initial jobless claims also began to trend up in the months before those recessions began (see Chart 2). Although jobless claims have picked up over the past month, the hurricanes are almost certainly to blame. Reassuringly, the solid upward trend in temporary help employment has continued unabated. Consumer sentiment is another source of leading information; having peaked around a year before the past two recessions (see Chart 3). These data are also soothing any nerves as the index has reached new cycle highs in recent months. Bank lending standards to corporates also tends to lead the economic cycle, with the proportion of banks tightening standards rising above the proportion loosening in advance of both the early 2000s and 2008/09 recessions. But here too the most recent trends have been positive; after tightening in the aftermath of the collapse in commodity prices between July 2014 and February 2016, lending standards have begun easing more recently. Meanwhile, financial market indicators are not signalling an imminent policy mistake either. The Treasury yield curve inverted more than a year before most of the post-war recessions, and though the curve has been on a flattening trend since 2013, its current slope is more consistent with the middle of the economic cycle than the end. That is consistent with the very benign signals we are getting from our financial stress index, which has been below its long-term average through all of 2017 so far. In fact, among the indicators that show policy is tightening too much, only housing and auto sales are providing any cause for concern, with both having slowed noticeably this year. However, there are idiosyncratic forces at play in both sectors and at least when it comes to housing there are reasons to expect the pace of sales to pick back up through 2018.