Dallas Fed President Robert Kaplan said that with the current fed funds rate at 1.75-2.00%, the Fed should continue raising interest rates until they hit their neutral level, which he said is about “three or four quarter-point rate increases away.”
“At that point, I would be inclined to step back and assess the outlook for the economy and look at a range of other factors—including the levels and shape of the Treasury yield curve—before deciding what further actions, if any, might be appropriate.” Even so, he admits that the shape of the yield curve, which yesterday dipped to a new post-crisis low of 22bps, “suggests to me we are ‘late’ in the economic cycle” although he mitigated the risk, saying “I do not discount the significance of an inverted yield curve.”
The Dallas Fed projects full-year GDP growth of about 3%, and notes that “2018 will be a strong year for economic growth in the U.S. Reasons include a strong consumer sector, improved prospects for business investment due to tax incentives, solid global growth and substantial fiscal stimulus due to recent tax legislation and budget agreements.”
However, echoing the analysis of his former employer Goldman, Kaplan cautions that “while 2018 will be strong, economic growth is likely to moderate in 2019 and 2020 as the impact of fiscal stimulus wanes and monetary policy approaches a more neutral stance. Their view has been that potential GDP growth in the U.S. is in the range of 1.75 to 2 percent and actual real GDP growth will likely reach this level by 2020 or 2021.”
Kaplan also expects unemployment rate to fall to 3.7% by year-end, and expects “headline personal consumption expenditures (PCE) inflation will remain in the neighborhood of the Federal Reserve’s 2 percent target during the remainder of 2018.”
“While our economists are hopeful that a strong labor market might continue to draw in new entrants who are currently out of the workforce, it is our base-case view that the current rate of labor force growth is unlikely to continue.”
What are the key challenges facing the Fed according to Kaplan? He lays it out in the concluding section “where we go from here” in which he notes the following: “the challenge for the Fed is to raise the federal funds rate in a gradual manner calibrated to extend this expansion, but not so gradually as to get behind the curve so that we have to play catch-up and raise rates quickly. Having to raise rates quickly would likely increase the risk of recession.“
The full section is below.
When I joined the Fed in September of 2015, the federal funds rate was 0.0 to 0.25 percent. This rate had not been adjusted since late 2008. The Fed’s balance sheet stood at approximately $4.5 trillion.
Since that time, the Fed has been able to gradually remove accommodation and implement a plan to reduce the size of its balance sheet. Over this period, the unemployment rate has moved down substantially and inflation is now running at approximately 2 percent.
At this juncture, the challenge for the Fed is to raise the federal funds rate in a gradual manner calibrated to extend this expansion, but not so gradually as to get behind the curve so that we have to play catch-up and raise rates quickly. Having to raise rates quickly would likely increase the risk of recession.
As I judge the pace at which we should be raising the federal funds rate, I will be carefully watching the U.S. Treasury yield curve. Currently the one-year Treasury rate is 2.44 percent, the two-year is 2.61 percent and the 10-year is 2.87 percent. My own view is that the short end of the Treasury curve is responding to Federal Reserve policy expectations. The longer end of the curve is telling me that, while there is substantial global liquidity and a search for safe assets, expectations for future growth are sluggish—and this is consistent with an expectation that U.S. growth will trend back down to potential. Overall, the shape of the curve suggests to me we are “late” in the economic cycle. I do not discount the significance of an inverted yield curve—I believe it is worth paying attention to given the high historical correlation between inversions and recession.
I will also be closely monitoring global financial and economic developments and their potential impact on domestic financial and economic conditions. As global financial markets and economies have become increasingly interconnected, the potential for spillovers to the U.S. is greater than in the past. That is, global economic and financial instability has the potential to transmit to domestic financial markets, potentially leading to a tightening of financial conditions which, if prolonged, could lead to a slowing in U.S. economic activity.
Based on these various factors, as well as the current strength of the U.S. economy and my outlook for economic conditions over the medium term, I believe it will be appropriate for the Fed to continue to gradually move toward a neutral monetary policy stance. I believe that this gradual approach to removing monetary policy accommodation will give us the best chance of managing against imbalances and further extending the current economic expansion in the U.S.