Economic Insights: Buzzword of the week: Flexibility

February 25, 2019

Buzzword of the week: Flexibility

“Flexibility” has overtaken “patience” as the trendy policy buzzword over the last week. While commentators are using the word most prominently to describe monetary policy, it could certainly apply to other areas as well. Last week’s release of the Fed minutes from its January meeting started the trend. The minutes showed a willingness on the part of the Fed to adjust monetary policy to broad economic and market conditions. While this obviously means the Fed is targeting the fed funds rate, it also indicated that they could use flexibility with some of their other policy tools, like their robust balance sheet. Normalization seems headed for a conclusion toward the end of this year, but the Fed’s role in policymaking does not appear over. And the outlook for the Fed funds rate itself also appears flexible, with some members of the Fed still tilting toward tightened monetary conditions while others seem less confident in the need for further tightening.

We stand by our view that wage growth (via labor market tightness) remains the linchpin for inflation and further tightening.

We stand by our view that wage growth (via labor market tightness) remains the linchpin for inflation and further tightening. It remains the key external force that could put upward pressure on inflation in a world where structural changes such as globalization and technological improvements are putting downward pressure on inflation.

With inflation often undershooting the Fed’s target rate of 2 percent, the Fed could temporarily allow inflation to run a bit hot (in excess of the target) since interest rates remain stuck at low levels.

Beyond the specific levers that the Fed can pull to adjust policy, interpretation of its mandate also appears potentially in flux. Chairman Powell will give his semiannual Monetary Policy Report testimony to Congress this week. While unlikely to signal specifics, a broad review of how the Fed makes policy, now underway, could include revisiting some long-held positions. For example, with inflation often undershooting the Fed’s target rate of 2 percent, the Fed could temporarily allow inflation to run a bit hot (in excess of the target) since interest rates remain stuck at low levels. Recently, powerful members of the Fed signaled a willingness to revisit the approach to inflation targeting. A number of options look available should the Fed so choose to change course.

Trade policy also looks more flexible

Trade policy also took a turn toward limber with the administration indicating that it would not increase tariffs on Chinese imports at the end of the week, its previously self-imposed deadline, citing progress in the trade negotiations. No hard agreements were hammered out yet, but we take this turn of flexibility as an optimistic sign for the economy. Current tariffs impart only a minor restraint on economic growth, but the escalation of tariffs could have produced a more deleterious impact. As we have previously stated, we do not expect a grand détente between the U.S. and China – the two countries remain too far apart on many critical issues. But in this case stopping looks like winning. We remain a bit concerned about the potential for ratcheting up trade tensions between the U.S. and Europe, with the administration rattling its saber about auto imports. The Department of Commerce recently delivered to the president its assessment of whether imported cars pose a national security threat. We view this potential turn toward trade restrictions as the wrong kind of policy flexibility.

Data for doves

Data releases last week likely provided fodder for those in the dovish camp for monetary policy. Both headline and core durable goods orders for December fell below expectations. These misses potentially signal that the slowdown in global economic growth, which we previously discussed, could depress demand for U.S. exports. Existing home sales for December declined while supply continues to slightly increase, indicating some potential cooling in the housing market. And despite a decline in weekly initial unemployment claims during the week ending February 16, the four-week moving average increased to its highest level since January 2018. Given the importance of the labor market to the overall economy, we remain keenly focused on weekly initial claims for any clear, meaningful sign of slowing in the labor market.

What it means for CRE

For commercial real estate (CRE), developments last week fell mainly on the positive side of the ledger. But we hesitate to read too much into any of them, particularly on the policy side. We need more time to see how the data is unfolding before we obtain more transparency on the policy front, especially monetary policy and the course for further rate hikes. The Fed’s willingness to change policy so abruptly (which we recently discussed) makes such projections even more challenging than usual. Regardless, we do not foresee that any of the potential policy outcomes will impact the economy and CRE market in an outsized manner this year. Therefore, we caution against feeling too optimistic or pessimistic about any of these decisions and remind readers to focus on underlying economic fundamentals. Growth remains positive though slowing and market conditions remain favorable, setting up 2019 for another good run for CRE.

What else we are watching this week

In addition to Chairman Powell’s testimony, a busy week for important data lies ahead. We are particularly focused on the shutdown-delayed fourth quarter GDP release. We believe that growth slowed during the fourth quarter toward the mid-2 percent range based on data released thus far, notably the drastically weak retail sales figure for December. This data will help us to finalize our economic outlook for 2019 which we will publish next week.

We anticipate that housing starts and building permits for December declined, another sign of cooling in the housing market. We believe that inflation for December, measured by the personal consumption expenditures index (PCE), remained tame and we expect core PCE, the key metric for Fed policy, to remain unchanged on a year-over-year basis. We look for the ISM manufacturing index for February to decline a bit, given signs of slowing in the economy.

Thought of the week

It cost roughly $44 million to produce the Academy Awards ceremony this year. The economic impact of the ceremony on southern California is about four times that ($150 to $250 million).

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