The new hawkish tone coming from the Fed

New Federal Reserve Chairman Jerome Powell gave his first extended remarks to Congress on monetary policy and the state of the economy yesterday. He came across as optimistic about future prospects for the US economy and employment market. His tone was more hawkish than Previous Fed Chair Janet Yellen.

Additionally, unlike previous Chair Janet Yellen, Powell expressed few concerns about social issues like inequality or low labor force participation that prevent an even transmission of Fed policy. Indeed, in questioning, he expressed the view that holding inflation in check was the best way of dealing with these issues because it hurts lower-income workers most. His tone was, thus, more hawkish. Though we can expect the Fed to stay committed to three rate hikes in 2018.

Hawkish Powell positive about US economy

One crucial place where Powell was particularly hawkish was in his longer-run assessment. His only concern was inflation if the economy overheated. Powell said:

In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis. While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds: In particular, fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory. Despite the recent volatility, financial conditions remain accommodative.

That’s an extremely positive outlook. It suggests not just three rate hikes or more in 2018 but even more afterwards to keep inflation in check. He followed this statement with boilerplate verbiage saying, ” the path of monetary policy will depend on the economic outlook as informed by incoming data”. But that’s a given. What matters is that his prepared remarks mentioned nothing that would hold this economy back.

That’s hawkish.

Powell believes we are at full employment

Powell didn’t even explicitly mention unemployment as a guide for policy going forward. His predecessor Janet Yellen has consistently done this, pointing to both inflation and employment in the Fed’s dual mandate.

For example, in the same setting before Congress in November, Yellen said this:

Even with a step-up in growth of economic activity and a stronger labor market, inflation has continued to run below the 2 percent rate that the Federal Open Market Committee (FOMC) judges most consistent with our congressional mandate to foster both maximum employment and price stability.

Yesterday, Powell only mentioned unemployment levels as a general reference. He explicitly avoided talking about it in a forward-looking context. Powell, therefore, likely believes we are at or near full employment. The fact that Powell did not specifically mention the employment side of the Fed’s dual mandate suggests it is less of a guide for policy for him.  Again, this is hawkish.

Powell appears to support the Taylor Rule

Moreover, immediately after this Powell gave support for “monetary policy rules” like the Taylor Rule. This is a guideline for monetary policy that Stanford economist John Taylor developed. It gives ballpark figures for interest rates given how high inflation is and how much slack in the economy there is.

Powell said:

In evaluating the stance of monetary policy, the FOMC routinely consults monetary policy rules that connect prescriptions for the policy rate with variables associated with our mandated objectives. Personally, I find these rule prescriptions helpful.

The Chairman added standard boilerplate about caution, saying “Careful judgments are required about the measurement of the variables used, as well as about the implications of the many issues these rules do not take into account. ” But the implication is clear. He prefers policy rules. And since he didn’t say specifically which rules, we can look to the Taylor Rule.  And the Taylor Rule says interest rates should be almost double the current level.

Supply Side economist Larry Kudlow also caught on to this. He was optimistic about what that means for Fed policy going forward. “I’ve never seen that in any testimony before,” Kudlow said. “Monetary rules — that is new for the Federal Reserve, and I think that’s progress.”

Expect continued commitment to existing policy path

We shouldn’t expect a deviation from the Fed’s stated policy path. That calls for three rate hikes in 2018. And this is where market speculation has been most acute. But given Powell’s hawkish tone, we should look for two things from the Fed going forward.

First, we should look at how Powell reacts to any increase in inflation. The Taylor Rule suggests the Fed is behind the curve. If Powell supports that rule and inflation rose, he would signal comfort with moving to four rate hikes in 2018.

Second, we should also look at what Powell signals about policy beyond 2018. So far, markets have been focused on the three rate hikes for 2018. But Powell’s remarks yesterday show someone prepared to keep the Fed’s rate hike train going far beyond 2018.

Overall, Powell’s testimony supports my view that the Fed has been and will continue to be more hawkish than the market expects. I believe long-term interest rates will grind higher. But look at the steepness of the yield curve for clues on whether the Fed is over-tightening.

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