US Monetary Policy Outlook: Delayed Tightening Amid Moderating Growth Prospects

23 Feb 2016

OVERVIEW

  • The Federal Open Market Committee (FOMC) is likely to raise the target range for the federal funds rate by just 50 basis points in 2016.
  • The most probable path is for the Committee to delay the next rate increase until September, as it pauses to take stock of more restrictive financial conditions and signs that growth momentum may be waning.
  • Indeed, GDP growth will likely moderate to a trend-like pace of around 1.75 percent this year, though the risks to this projection are skewed somewhat to the downside. With less progress towards closing what remains of the output gap, the risks of an inflation overshoot are even lower than the Committee perceived at the time of liftoff.

Just two months after starting a policy tightening cycle, the Federal Open Market Committee (FOMC) finds itself in the uncomfortable position of seeing mounting evidence that its 2016 projections for above-trend growth will prove untenable. In fact, recession risk may be higher now than at any point during the post-crisis recovery. As a result, the FOMC will likely delay an additional policy rate increase until at least June, and most likely until September, in order to take stock of downside risks to the outlook. Before policy tightening can resume, a number of pieces will first need to fall into place. At the very least, financial conditions would have to ease and inflation expectations pick up along with realized inflation, and the service sector would need to regain some of the momentum lost over recent months. Our confidence in these outcomes over the near term is not particularly high, as they are dependent on clear signs of improving global growth, resilient consumer and business confidence, an absence of significant dollar appreciation, and a recovery in oil prices.

This note is structured as follows. The next several sections lay out the factors that are likely to cause a deceleration in growth this year or slow progress towards the two percent inflation objective. These factors include tighter financial conditions, falling inflation expectations, slowing service sector momentum, more restrictive bank lending standards for corporate loans, and declining corporate profit growth. The concluding section discusses near-term recession risks, as well as two different scenarios for monetary policy this year.

Tighter Financial Conditions

Tighter financial conditions remain one of the primary reasons why 2016 growth will come in meaningfully below the FOMC’s median economic projection made at the time of lift-off. Indeed, financial conditions have now been tightening for well over a year, and by some measures are more restrictive than at any point since 2009. The catalysts behind tighter conditions are varied, and include the drawn-out and uncertain approach of Federal Reserve policy tightening over the course of last year, mounting concerns about China’s growth outlook and economic management, and rising default risks in the US high yield oil and gas sector. In the aggregate, the tighter conditions these developments have engendered will serve as a drag on consumer wealth and confidence, and constrain business investment and hiring. In addition, prior dollar strength will continue to weigh on net exports.

When we model the impact of last year’s stock market declines, dollar strength, and credit spread widening, we find that the tightening of conditions, if sustained, could subtract around one percent from our baseline growth forecast for 2016, shrink monthly payrolls growth to around 100,000, and dampen the inflation outlook. We do not take this modelling exercise as verbatim, especially since some of the growth effects of tighter financial conditions likely already occurred last year1. Still, the results provide support for our conviction that US growth this year will slow to around 1.75 percent, with risks to that projection now skewed to the downside.

One way to think about the linkage between financial conditions and monetary policy is to consider that markets have already done the work for the FOMC. By gradually raising the policy rate, the Committee had sought to tighten financial conditions in order to slow the economy back towards a two percent growth rate (the median Committee participant’s estimate of trend) and prevent an inflation overshoot. To the extent that tighter financial conditions will already weigh on growth and inflation this year and possibly next, the Committee will have a greatly reduced need to raise rates over the medium term. In fact, according to our model, last year’s tightening of financial conditions was the equivalent of about 150 basis points of policy rate increases, in terms of the estimated macro effects.

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