The Fed’s Brief Return Engagement to Center Stage

Today’s jobs report is largely consistent with those in recent months, which means the job market remains surprisingly strong. Indications are the overall economy accelerated markedly in the second quarter, suggesting the economy is taking a lot of momentum into the second half of the year.

Like it or not, the Federal Reserve will soon be taking up residence center stage. The Fed’s decision at its June meeting to raise the funds rate to 2% was just a warmup act.

When last the Fed took center stage, the U.S. economy was climbing out of the Great Recession and associated financial crisis. The Fed cut its key monetary instrument – the Fed funds rate – to near zero. It embarked on a series of massive quantitative easing programs, acquiring in the process nearly $3.5 trillion in assets. On balance the Fed’s program worked – financial markets stabilized and the economy recovered.

Then the Fed’s public profile receded. Financial markets took note when the Fed announced the end of active quantitative easing. Note was also taken when the Fed began nudging the Fed funds rate up again. Note taken, but aside from a few media reports, few others noticed.

The Fed’s normalization program that began in December of 2015 continues apace with June’s quarter-point hike. To be clear – rather than tightening monetary policy, the Fed is reducing the amount of support provided. The difference is analogous to that between taking one’s foot off of the car’s accelerator versus depressing the brakes.

The Fed has signaled and financial markets expect such rate hikes to continue into 2019. Unclear is where and when the Fed will halt such increases, assuming inflation and inflation expectations remain consistent with the Fed’s 2% target. And assuming the economy is otherwise running normally.

As described in September of 2014, the Fed’s plan for normalizing policy includes gradually raising the funds rate to “normal” levels and gradually reducing the Fed’s securities holdings to more normal levels. The Fed initiated normalizing its balance sheet beginning in October of 2017 in the amount of $10 billion a month, an amount expected to increase to $50 billion a month over time. The Fed’s posture will remain supportive until both tools – the Funds rate and the balance sheet – have returned to normal.

Chairman Powell’s first big challenge

Curiously enough, the 2017 tax reform complicates the Fed’s program. Despite the banter about tax reform’s immediate effectiveness, tax reform was always expected to have its most important effects spurring business investment and long-term growth beginning in earnest toward the latter half of 2018. Prior to tax reform the Fed anticipated a fairly strong economy. With tax reform’s effects in train, the Fed will have to interpret the anticipated tax reform-induced acceleration and its effects on inflation carefully.

Some economists are already convinced the Fed will act precipitously, causing a recession in 2020. The argument rests on the belief tax reform will overheat the economy going into 2019, this despite many of their earlier judgments tax reform would have little to no effect on growth. To head off rising inflationary pressures from an apparently overheating economy, these economists then argue, the Fed will raise the funds rate in 2019 to where the Fed is substantially leaning against the economic winds, thus triggering the recession.

While a 2020 recession scenario can’t be ruled out, it seems unlikely. To begin, the investment-related accelerated growth beginning in the second half of 2018 will expand the productive side of the economy. Rather than pushing the Fed, standard economics suggests that increasing supply rapidly would put downward pressure on inflation thereby mitigating the Fed’s need to act.

We saw an earlier version of this movie not long ago. The mid-1990s economy chugged along and then got a major boost from the spreading adoption of a new technology – the Internet. Some warned the economy would overheat, and the Fed needed to tighten. Then-Fed Chairman Alan Greenspan saw something else in the data. He saw the accelerated growth. But he also saw labor productivity accelerate from the technology-based supply side shock. He resisted the inflation hawks, allowed the economy its head, and the 1990s boom ensued. And what of inflation during the period? It fell from 2.1% in 1996 to 0.8% in 1998 before recovering to just over 2%.

By the late 1990s the stock market suffered the dot-come bubble and one can debate whether Greenspan should have pre-emptively taken the air out of the bubble in 1999 or so. But Greenspan’s arguable miss at the end of the decade doesn’t vitiate the kudos he earned from wise policy choices in the middle.

The Fed under Chairman Greenspan saw a positive supply-side shock in the 1990s and quite properly let it ride. Today, Fed Chairman Jay Powell has this history at his fingertips. He knows the acceleration expected later in 2018 and beyond will be due to a supply-side surge triggered from tax reform and the resulting rapid growth in business investment. If for whatever reason inflation and inflation expectations lose their anchor of around 2%, then the Fed may be forced to take away the punch bowl. Otherwise, Powell should let the economy party and enjoy tax reform’s full benefits.

About the authors

J.D. Foster

Dr. J.D. Foster is the former senior vice president, Economic Policy Division, and former chief economist at the U.S. Chamber of Commerce. He explores and explains developments in the U.S. and global economies.