A quick update to our February note “Will the Fed Hike Again? FRB-US Says “No”, Unless…”. Not much has changed and the conclusion remains the same: according to FRB-US, the Fed is not expected to hike again, unless core PCE (YoY) re-accelerates above 5%. This conclusion remains true under many scenarios, including assuming a higher R* (unless one assumes an unreasonable level of R* equal to 2.0%). In all other, more realistic, scenarios, the Fed is expected to keep rates high for longer.
If the reader has questions, please direct them to our FRB-US specialist: Tilda Horvath (tilda.horvath@underlyinginflation.com). Tilda has programmed FRB-US at the Board and managed the model for almost 20 years. We remind the reader that we run ad-hoc scenarios using FRB-US free of charge. Do not be shy.
Preamble – why we pay a lot of attention to FRB-US. Last January, FRB-US estimated a large positive supply shock on the US labor market (our notes here, here, and here), driven by higher participation, higher productivity, and a larger population size. Then, in February we used the model to simulate under what conditions the Fed could hike again (our note here); the result was that the model did not see a hike without core PCE (YoY) above 5%. In all other scenarios, the model expected the Fed to recalibrate to a “for longer” message. Indeed, the communication from the Fed staff and FOMC participants since then confirmed the FRB-US estimates. Specifically:
- The March FOMC minutes showed that “The economic projection prepared by the staff for the March meeting was stronger than the January forecast. The upward revision in the forecast primarily reflected the staff’s incorporation of a higher projected path for population due to a boost from immigration”. As FRB-US suggested, the Fed staff revised up Y* (the level and possibly also the slope) due to a positive supply shock on the labor market.
- On April 3rd, Powell said “How does inflation come down? It’s because [the] potential capacity of the economy has actually moved up, perhaps more than the actual output. So, it’s a bigger economy but not a tighter one”. This confirms that in Powell’s mind the level of Y* is higher and that the output gap is smaller (or even negative), as estimated by FRB-US back in January.
- On April 15th, Fed’s Williams said “I’m getting more optimistic about potential growth”, adding that “US potential growth is around 2%”.. which is precisely what FRB-US estimated back in January (see our note here).
- Finally, a sequence of statements from FOMC participants confirmed that the baseline case is for no additional hikes, and a “for longer message”. The FOMC could consider another hike in case, but only if the data would require it. Fed’s Williams on April 18th: “Fed rate hikes are not my baseline forecast”, “If data called for higher rates, the fed would hike”. Fed’s Bostic on April 18th said: “We won’t be able to reduce rates until towards end of the year”. Fed’s Powell on April 16th said: “If higher inflation persists the Fed can maintain current rate as long as needed”. Etc…
The new simulations
No hike, “for longer” is the message for now. We have updated the baseline using our GDP/PCE/labor market nowcast for Q1 and Q2 (a new FRB-US dataset will be released soon, and we will circulate a new baseline shortly after that). Figure 1 shows the results of a set of simulations. As usual, the red line shows the current FRB-US “inconsistent/unconstrained” baseline. All other lines show scenarios assuming that going forward core PCE will exogenously grow at a constant rate of 2.5% (green line), 3.5% (gray line), 4.5% (purple line), and 5.5% (orange line). The bottom line remains the one of last February: there is no hike going forward; in case, the Fed is expected the delay the cuts (“for longer”). The model delivers additional hikes only if core PCE (YoY) re-accelerates above 5%.
Note: please, note that in a few days we will get Q1 GDP figures and possibly a new FRB-US database. Therefore, the evidence in Figure 1 can change, although the overall message should remain the very same.
Figure 1. FRB-US baseline (red line) and scenarios (all other lines)
Note: Real GDP growth and core inflation are expressed as YoY. Core inflation is core PCE price inflation. The red lines show the “inconsistent FRB-US” forecast (the current baseline), that is the model-based forecast removing the “add-factors” put by the Fed staff to match the latest SEP, updated as specified in the text.
A document showing the path of some financial variables, including the 5y-10y-30y yield, consistent with the scenarios in Figure 1 can be seen here.
What if R* is higher? And what if growth will be stronger?
No hike, unless one assumes an unreasonable R*. In the simulations above, we have assumed that R*=0.8% (a bit stronger than in the latest SEP, anticipating additional upward revisions in upcoming rounds), and that GDP growth is robust in H1. Figure 2 shows three scenarios in which we have assumed an exogenously higher real GDP growth rate and a higher R*. Specifically, the green-line scenario assumes (via add factors) that real GDP growth will be 2.5% QoQ (saar) going forward. The other two lines assumes a higher GDP growth rate but also a higher R* (1.5% in the gray-line scenario, and 2.0% in the purple scenario). The bottom line is clear: assuming a strong economy a bit above potential or a higher R* per se are not enough to have a hike. The only way to have a hike is to assume a (unplausible) R* of 2.0%. (The intuition for this result is that in these scenarios core PCE stays above target but does not re-accelerate. Therefore, the Fed does not need to hike again).
A document showing the path of some financial variables, including the 5y-10y-30y yield, consistent with the scenarios in Figure 2 can be seen here.
Note: the gray and purple scenarios are built assuming a real GDP growth of 2.5% QoQ saar going forward, as in the green-line scenario via add factors. However, because we also assume a higher R*, there is a feedback from tighter monetary policy in the general equilibrium and, in the end, real GDP growth is lower than in the green-line scenario.
Figure 2. FRB-US baseline (red line) and scenarios (all other lines)
Note: Real GDP growth is expressed as YoY.
Conclusion and implications for the Fed
Once again, FRB-US has correctly anticipated the Fed. The main message of today’s note is that at the moment, according to FRB-US, it remains very difficult to see another rate hike, unless one assumes a (implausible) level for R* or core PCE above 5%. Not only, but FRB-US correctly estimated the positive supply shock on the labor market in recent months. For this reason, we think that recent FOMC participants communication is genuine and keeps following the Fed staff view which is informed also by FRB-US: for now, it is “for longer” even if it remains unclear for how long before cutting.