The Federal Reserve (Fed) reassured markets that its rake hike pace would remain gradual with the release of its May 1–2 policy meeting minutes last Wednesday. While the minutes revealed a generally upbeat assessment of the economy consistent with Fed views since the start of the year, markets read the overall tone of the minutes as modestly dovish, helped by some context on the Fed’s additional emphasis that its 2% inflation target is “symmetrical.” The language has been widely used in the minutes and statement for some time, but garnered closer scrutiny after the policy statement added the phrase again in a key passage. By highlighting that its inflation target was symmetrical, the Fed reminded markets that it does not think of its target as a line in the sand, but as a goal that will have some wiggle room.
In response to the minutes, shorter maturity Treasury yields and marketimplied rate hike expectations fell, while equities moved higher. The takeaway for markets is that for now, the economy remains in a sweet spot. It’s healthy enough that the Fed is slowly normalizing policy, as it should, but at a pace that will allow economic momentum to continue. We agree with this assessment, and while the potential for policy acceleration remains a risk, the current focus should remain on above-trend economic growth and what it means for consumers, businesses, and markets.
THE SETUP: WHAT MARKETS WERE WATCHING
While there is little to indicate that the economy is overheating and inflation shows few signs of running hot, there are signs that the economy is in the late stage of the economic cycle, when the excesses that cause recessions start to build. Growth is expected to run above its long-term potential, labor markets are getting tight and it’s getting harder for businesses to find people with the right skills, and the federal government is accelerating deficit spending at a rate unusual outside of recessions and wartime. Despite its name, the “late” stage of the economic cycle is actually often a period of strong growth accompanied by rising markets and typically lasts several years.
Nevertheless, as excesses build, market participants will carefully eye the Fed for signs that they are putting on the brakes. We are not near that point right now. The Fed still characterizes its policy as accommodative; that is, adding support to the economy instead of maintaining just a neutral stance. But given how long that period of accommodative policy has lasted and the role the Fed has played in sustaining the expansion, even a shift from accommodative to neutral brings with it a sense of uncertainty.
The Fed’s assessment of the economy has generally improved over the last year, but its gradual pace of policy normalization has allowed good economic news to continue to be good news for markets as well. Inflation is the main gauge to watch to judge whether this can continue. In fact, the catalyst for the market volatility that began in late January was concern that wages were beginning to push higher. Inflation has picked up and the Personal Consumption Expenditure Index (PCE) ex-food and energy, the core version of the Fed’s preferred measure of inflation, has accelerated toward the Fed’s 2% target but has not yet breeched that level, and in fact has not been over target since a brief stretch in early 2012.
As the economy continues to improve, Fed watchers have been speculating whether the expected three rate hikes in 2018 are likely to become four. The difference between three and four rate hikes in a year is actually not that meaningful in itself, but it does signal the economy is running hotter than the Fed expected at the end of 2017 and would imply that the path for rates would be accelerated, assuming continued confirmation from the data