Economic Commentaries

02

Fed Chair Powell offered his view of monetary policy at last week's annual Jackson Hole Wyo. conference. He attempted to thread a proverbial needle, arguing against those believing Fed policy risks being too aggressive, while fending off criticism from those believing the Fed is being too tardy, risking a financial bubble and inflation.

With the Chairman highlighting that the Fed's goals of economic growth and price stability are being met, he suggested the best course is for policy to continue toward reaching rate neutrality, without quantifying what may be the neutral rate. The first reaction from financial markets was positive as equities rose, the dollar eased, and bond rates held steady.

Our view is that the Fed is risking being too aggressive if it continues on its present course. The Fed Chairman suggested that evidence in either direction would cause the FOMC to quickly adapt. We think the next few quarters will provide evidence supporting our view. As a precedent we hark back to the mid 1990s. At that time Fed Chairman Greenspan backed away from a diet of raising rates as he detected a surge of productivity flowing from newly emerging technologies. He was right and the economy dazzled.

For the past eighteen months we have been suggesting that a decade long abysmal productivity performance was ending. This we felt was being prompted by deregulation, a more business friendly tax structure, and a more favorable capital-labor ratio. Productivity trends have been improving in fits and starts over the past year. In the spring quarter the rise was at an explosive 2.9% annual rate versus 1.3% over the past year. Such a rapid rate is not a new normal. But preliminary indicators are that productivity will once again improve in the current quarter, suggesting that perhaps 2% may be the new normal. This could be a positive catalyst for markets and for the Fed to rethink whatever might be its bias of a neutral rate.

There are obstacles to a productivity renaissance. Specifically business investment is a bulwark and the most recent data suggest continued robust growth. But business spending plans appear to be wavering in the face of mounting trade tensions. A resolution of NAFTA negotiations is a positive but is not the main event for either investors or business. The main event is China and to data there is scant evidence of progress.

Trade issues were avoided in Powell's remarks at the Jackson Hole conference. But the minutes of recent meetings certainly point to concern. Nonetheless, the FOMC is almost certain to hike its target rate again at its September meeting. This would likely further flatten the interest rate yield curve which may or may not be a warning of approaching trouble. But a productivity surge is unequivocal, and with unit costs under control and commodity prices having eased, the FOMC could signal that is closer to its definition of the neutral rate than perhaps market expectations are reflecting.

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