Federal Reserve watchers have spent the better part of a decade arguing about what policy normalization should look like. Last week, in response to events over the past few months, the Fed declared monetary policy more or less normalized. With the Fed seemingly out of the picture for the time being, if the economy cooperates, we may finally get a chance for the first time in decades to see what economic overheating looks like.
Monetary policy doves have continually been disappointed this decade because they’ve felt like the Fed has been overly hawkish long before the labor market was at full employment and there were signs of inflation pressures. The Fed began its “taper” — the wind down of security purchases during quantitative easing — in 2013, when the unemployment rate was still close to 7 percent. The first interest rate increase of this cycle took place in December 2015, when the unemployment rate was at 5 percent and during a period when the global economy was weakening with a decline in commodity prices. Given where unemployment and inflation currently stand, with the benefit of hindsight, monetary policy doves argue the policy normalization process began too soon and interest rate increases have occurred too rapidly.
Supporters of the Fed argue that the Fed is balancing multiple objectives and operating in an environment of uncertainty. There have been periods this decade when officials have maintained a hawkish bias because they were worried about overheating in financial markets, given the problems that financial market excesses created in the past two economic cycles. Knowing what level of labor market tightness will lead to an acceleration in wage growth isn’t an exact science — in hindsight we can now see that we finally got a breakout in wage growth in 2018, but for all the Fed knew that could’ve happened two years earlier or two years later. The central bank didn’t want to get caught having to play catch up and risk having to raise rates faster than officials or markets were comfortable with.
The key with all of this is that the debate has occurred in the context of “normalization” — getting monetary policy back to “normal,” if such a thing exists. In the FOMC statement last week, the Fed noted it will be patient as it thinks about “future adjustments” to monetary policy. In other words, the next move could be either a hike or a cut. For all intents and purposes, the Fed and markets consider policy normalized for now.
Anything more than one additional interest rate increase from here not only would invert the U.S. Treasury yield curve — sending long-term yields lower than short-term yields, an ominous sign that has tended to portend future recessions — but also would signal that the Fed is seeking to actually slow the economy, perhaps even being willing to cause a recession in the name of fighting inflation. A debate about that, whether it be in financial markets, inside the Federal Reserve, or with Congress and the White House, will be far different.
For that reason, there’s probably a high bar to getting multiple interest rate hikes from here. It would probably mean some combination of all-time highs in stocks with financial conditions that have the Fed worried about a destabilizing bubble, wage growth in excess of 4 percent, or a true breakout in inflation expectations and actual inflation.
What this means is that with monetary policy normalized, we may finally get a chance to see if the real economy can “overshoot” assuming above-trend economic growth continues for a while longer. Unlike in the past two economic cycles, we have neither signs of financial market nor business investment excess. While investors will always wonder when the Fed might ruin the party, in 2019 markets and the economy look poised to have some breathing room.