The Fed: Fed has to start considering the risk of a recession, former governor says

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Bloomberg
Laurence “Larry” Meyer, president of Monetary Policy Analytics, served on the Fed’s board under Alan Greenspan and remains an influential Fed watcher.

The Federal Reserve has to start factoring in the rising risks of a recession to its policy actions, former Fed governor Larry Meyer said in an interview with MarketWatch.

“We’re at a point here where we’ve got to be thinking about a recession risk,” Meyer said.

A recession is not in view yet, “but it jumps out,” when you look at the outlook, Meyer said.

In his latest forecast, Meyer said he is forecasting a sharply decelerating growth path for the economy. “The economy is projected to be on a sharply decelerating growth path. With that trajectory, you have to ask yourself” about recession risks, he said.

A weaker outlook “will come into focus very sharply by the middle of next year, when the economy, presumably, we think, is going to slow down from a 3.25% [growth rate] to below 2.5% on its way to 2%,” he said.

“The Fed has to be careful here,” he said.

Meyer said he thinks the economy will slow enough by 2021 that the unemployment rate will start to tick higher.

The Fed does not have a good historical track record of pushing up the unemployment rate without causing a “full-blown recession,” Boston Fed President Eric Rosengren noted recently.

With the economy slowing down, and higher interest rates starting to bite, President Donald Trump’s criticism of Fed Chairman Jerome Powell is only going to get worse, Meyer said.

“The Fed has to be careful here.”

Larry Meyer

“Can you imagine what happens if employment growth is slowing to 100,000 and growth is moving to 2% as we head toward the 2020 election, [and] after a period of rising rates,” Meyer said. “We ain’t seen nothing yet,” he said.

Meyer said the Fed is likely to stop its tightening cycle by the end of 2019, once interest rates get to a modestly restrictive level.

“We think they are going to go above neutral and we think part of the reason is maybe they’ll stop. Maybe by the end of 2019. A pause that evolves into stopping,” Meyer said.

The Fed’s estimate of neutral is between 2.75% and 3%. At the moment, the Fed’s benchmark short-term rate is now in a range between 1.75% and 2%.

The Fed’s own forecast has the benchmark rate hitting 3.1% in 2019 and rising to 3.4% in 2020.

The market has the Fed stopping short of neutral, in a range of 2.5%-2.75% by next September, according to Fed funds futures contracts, noted Omair Sharif, senior U.S. economist at Societe Generale.

Meyer thinks the Fed will maintain its one rate hike per quarter pace until June.

Meyer said there is broad agreement among Fed officials to keep raising rates until they get to neutral. “It is so important to withdraw accommodation at this point, in their view, that it is a no-brainer,” he said.

Read: Fed officials ‘singing the same tune on rosy economic outlook, Evans says

In contrast, the hurdle to going to a restrictive policy is higher, Meyer said.

But, in the end, the hawks on the committee should carry the day and push for a more restrictive level, he said.

“Right now, the financial stability argument is being used, and I think appropriately, by those [on the Fed] who…probably think they need to go to a modestly restrictive territory,” Meyer said. “I would support that argument,” he added.

Moving beyond neutral will “build in a little insurance by stopping in a position where they are at least leaning against inflation pressures, without hammering the economy in a way that is likely to precipitate a recession,” Meyer said.

He noted that going to an outright restrictive policy is a very good predictor of recession.

At the meeting next week, Meyer said the Fed is certain to raise its benchmark rate by a quarter percentage point. He said the Fed would retain the language describing policy as “accommodative.”

A rewrite of the policy statement won’t happen until March or June, he said.

At the moment, the Fed statement says that “the stance of monetary policy remains accommodative.”

The big point is the Fed is tightening to remove accommodation, Meyer said. So removing the phrase would mean that the task of removing accommodation has ended and policy is near neutral.

“That would be a tremendously dovish signal at this point. They’re not close,” he said.

The flattening of the yield curve will not deter the Fed form tightening even though a inversion of the yield curve has been an “extraordinary” predictor of recession. The yield curve refers to the spread between long-and short-dated maturities, such as the 10-year Treasury note and the two-year TMUBMUSD02Y, -0.12%   Typically the curve slopes upward. A flatter curve suggests caution.

“There is a good case that this time is different,” he said.

The so-called term premium may be zero and that means the yield curve will be inverted half the time, he said. While the yield curve should not be ignored, “of course it is not a signal,” he said. The term premium is extra compensation investors demand for holding a long-term Treasury security such as a 10-year note TMUBMUSD10Y, +0.09%  .

See: Fed’s Rosengren says yield curve is not an important indicator

The trade war with China is also not going to derail the Fed, he said.

“We’re not to a point those spillovers [from trade] are sufficient to deter the course they are on,” he said. It might be different if the economy was growing at 2% annual rate rather than the 4.2% rate seen in the second quarter.

On the issue of financial stability, Meyer said he didn’t see much risk that rates would get to a level that would prick any latent asset bubbles.

Instead, “the story is, if we have a shock, will the rich valuations amplify any downturn,” he said.

Meyer was a co-founder of Macroeconomic Advisers which let economists use a standard macro model to come up with their own economic projections. The firm also took indicators and plugged them in its own forecast. In early 2016, Meyer left Macroeconomic Advisers and started his own firm, Monetary Policy Analytics.

Stepping back, Meyer said “now is a strange time” for the U.S. economy and monetary policy.

The unemployment rate is 3.9%, well below the Fed’s 4.5% estimate of non-accelerating inflation rate of unemployment and inflation is projected to remain near the 2% target.

“The question here facing the committee is, ‘is this time different?,’” Meyer said

“It better be, because the Fed is following a policy that is dramatically different than what they’ve done in the past,” he said.

Will they pay a price? That is a risk, Meyer said.

“The risk is that the Phillips Curve is steeper than it appears to look. What may happen at some point is that you’ve lost the game because inflation is rising to an unacceptable degree.”

If inflation begins to rise sharply, the Fed will be forced to move into deeply restrictive policy stance, he said. And that means a recession.

“Inflation is recession,” he said.

In this treacherous time, Powell has said he will be guided more by actual data and than unobservable estimates like the non-accelerating growth rate or the neutral rate of interest rates.

Powell laid out a policy doctrine in a speech in Jackson Hole that roughly translates into “you’ll know it when you’ll see it,” Meyer said.