What will drive US monetary policy from here?

19 May 2023 , 10:04 AM

When we talk of RBI monetary policy, one of the obvious question is; what is the US Fed doing? It is not about whether the Indian economy is similar or dissimilar to the US economy. The question is, can the Indian monetary policy really afford to be insular in an increasingly inter-connected global financial market. This may sound simple but monetary divergence is a risk that most of the macroeconomy managers are not willing to run beyond a point. A key question to ask, therefore, is where is US monetary policy headed from here.

Fortunately, the governors of the US Fed are extremely active at various forums expressing their view on some of the most critical and pressing macro issues. In a recently speech delivered at the National Association of Insurance Commissioners (NAIC), Governor Philip Jefferson outlined the imperatives for the US monetary policy and what would drive monetary policy in the US from here on. At a time when the US Fed appears much closer to the top of rates, the big question is where US monetary policy goes from here?

Driver 1 - Aggregate Economic Activity

One of the positive features of the current situation is that, despite the stress in banking and rising inflation, the aggregate economic activity remains robust The GDP growth in the US may have slowed to 1.1% in Q1CY23 compared to 2.6% in Q4CY22. However, Jefferson still expects the second quarter GDP of the US economy to be robust. However, the governor is of the view that the growth in Q2 would be slightly slower than in Q1. Recent data analysed by the Fed has shown signs of weakening spending, including a sizable fall in April 2023 in consumer sentiments.

However, Jefferson does not expect the second quarter to dip into recession nor show negative growth, but it is likely to be below the 1% mark; and that weakness is likely to continue for a better part of 2023. This slowdown can be attributed to a combination of factors like continuously tight financial conditions, low consumer sentiments, and a decline in household savings that had been boosted after the onset of the pandemic. In the words of Jefferson, another contributor to the slowdown could be bank lending restraints as the mid-sized banks get cagier about extending consumer credit as they would be looking to put their liquidity to better use.

Driver 2 – Labour (job) market

There is an interesting connection here. If the Fed keeps raising rates but wages are already high and still rising due to labour shortage, then inflation may not dampen. That is the situation we had in the US for the last 1 year but that may be gradually starting to change. Most experts contend that the current labour market in the US is one of the strongest that workers experienced over the last many decades. In the month of April alone, the US economy created 253,000 jobs and the unemployment rate fell to a 54 year low of 3.4%. Ironically, job creation has been remarkably resilient despite tighter financial conditions. 

If you look at the first 4 months of 2023, businesses have added 280,000 jobs a month on an average. To be fair, that is lower than the 350,000 a month created in H2-2022, but it still shows a lot of robustness in jobs data. The bigger reason why inflation is taking time to react is that the wage growth is persistently running ahead of the pace that is normally consonant with 2% inflation and productivity growth. Typically, wage gains are welcome, but when they are out of sync with productivity, then it is automatically inflationary. Labour is not as vibrant as 2022, but still contributing to inflation. 

Driver 3 – Inflation, of course

To a large extent, the outlook for US monetary policy will depend on the outlook for consumer inflation. The general view of the Fed is that while inflation has fallen substantially since last summer, it is still too high and the momentum is waning. The Fed uses personal consumption expenditures (PCE) inflation; which fell to 4.2% in March 2023 from 5.1% in February. This was largely driven by cheaper energy and food and both look sustainable for now. However, Fed started out with a target of 2%; and that is far away.

According to Jefferson, monetary policy has to address core inflation more than food or energy inflation. It is core inflation that provides a guide to discern longer-lasting movements in inflation. Indications are that after the fall in March, core PCE inflation should also stabilize in April, like consumer inflation has done. Within core inflation, the core goods inflation has fallen, but core housing service inflation is still too high at 8.2%. To add to it, inflation in non-housing services is also elevated at 4.5%. All in all, the  momentum of inflation fall has been slackening and that leaves room for further Fed hawkishness.

Driver 4 – The long arm of the banking crisis

Jefferson has expressed hope that the US banking system is resilient and would continue to play an important role in providing credit to households and businesses. However, the recent banking stress signified by the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank will result in banks tightening credit standards further. For now, the tightening has been moderate, but push comes to shove, things could get a lot tighter. In the last 3 months itself, Fed report credit tightening by 46% of the banks. 

There is one interesting perspective on the banking crisis. To quote Jerome Powell, the banking crisis could act as a supplement to hawkish monetary policy. Hence, the need for the Fed to increase rates further may be largely reduced. It is hard to say how much of this tightening is already done and how much more was in store. The corollary is something like this. If banks are expected to tighten credit, then households would proactively tighten. That would meet the purpose of the Fed anyways. 

To sum it up, major monetary policy considerations

Jefferson has underlined that going ahead, the Fed would be purely data driven and not view driven. Some key data points in the coming weeks include economic activity for April and May, employment report for May, Consumer Inflation for May 2023, and the April and May PCE inflation. As Jefferson underlined, the conduct of monetary policy is not just about reducing inflation but also tapering inflation expectations. But in an era of macroeconomic uncertainty, it is the data driven approach that is most likely to be used by the Fed.

Interestingly, the Fed has been always driven by the dual goals of price stability and maximum employment. Quite often, these 2 goals can be at cross purposes. The current situation presents such a dilemma. On one hand, inflation is too high and the progress in reducing inflation has been slow and painful. On the other hand, GDP has slowed considerably this year but the impact on the labour market is rather muted. 

The challenge in monetary policy is that it tends to work with long and variable lags; which may extend well beyond a year. More so when the economy is recovering from a flood of liquidity infused during the COVID pandemic. In the coming Fed meetings, the members are likely to add one more data points for analysis; which is the implications of tighter lending standards. For now, the message is that the Fed is not relenting in its battle against inflation in a hurry. Jobs, growth, and banking crisis have merely added a new dimensions to the monetary policy story.