The author is the professor of practice and senior director of the Oregon Economic Forum at the University of Oregon, and the author of Tim Duy’s Fed Watch.
Federal Reserve policymakers are likely enjoying this month about as much as market participants are.
Central bankers at the Fed don’t like fast-moving markets to begin with, and they especially won’t like the implication that their supposedly inconsequential 25-basis-point interest rate hike in December was a mistake. The only saving grace for the Fed is that January was off the table for a rate hike anyway, so the volatility on Wall Street will have little impact on this week’s policy outcome, due to be announced on Wednesday.
So the focus falls on the rest of the year. The evolution of monetary policy is largely dependent on whether the current selloff is a harbinger of recession. If it is, then this just became a one-and-done. That’s easy. If not, the Fed will try to play catch-up later this year—not unlike what it did in the wake of the Asian financial crisis of the late 1990s.
Wall Street is struggling with a big call: Is the U.S. economy being hit with a sector-specific shock, or an economywide shock?
I don’t think it’s an economywide shock, which obviously places me in the “no recession” camp. The Fed is in the same place. In a recent speech, Federal Reserve Bank of New York President William Dudley summed up the situation:
In terms of the economic outlook, the situation does not appear to have changed much since the last [Federal Open Market Committee] meeting. Some recent activity indicators have been on the softer side, pointing to a relatively weak fourth quarter for real GDP growth. But this needs to be weighed against the strength evident in the U.S. labor market. I continue to expect that the economy will expand at a pace slightly above its long-term trend in 2016. In other words, I anticipate sufficient economic strength to push the unemployment rate down a bit further and to more fully utilize the nation’s labor resources.
That said, policymakers are growing nervous that their plans for a series of rate hikes this year will prove to have been an optimistic pipe dream. Fed Vice Chairman Stanley Fischer may have been just a little overconfident when he complained that market expectations of rate hikes this year were too low. St. Louis Fed President James Bullard, a noted hawk of late, was more cautious given five-year forward-inflation expectations:
Bullard told reporters after his speech that strong U.S. employment would argue that the FOMC’S median projection of rate increases totaling 1 percentage point this year is “about right,” while inflation and price expectations concerns “would tend to push off rate increases.” Bullard said he would put more weight on expectations if they continue to decline.
Boston Fed President Eric Rosengren sang a similar tune:
While officials’ median projection last month provides a “reasonable estimate” for the likely path of the policy rate in 2016, that forecast faces “downside risks,” Rosengren said Wednesday in the text of a speech to the Greater Boston Chamber of Commerce. “I will remain highly attentive to foreign economic conditions, any weakening of the domestic economic situation, and the path of U.S. inflation.”
Given such concerns, why do Fed officials look so committed to higher rates this year?
Partly, it’s posturing. They don’t want to get sideways with financial markets and see a repeat of 1994, when a surprise tightening cycle roiled markets. They’d prefer to overpredict and underdeliver (a preference that may turn out to be bad strategy, as it perpetuates overly hawkish expectations). But it stems also largely from the concern that oil and the U.S. dollar are placing temporary pressure on an inflationary spring in the economy, and that spring will be unleashed when those temporary factors dissipate.
For instance, back to Dudley:
In my assessment, this is due mainly to weaker energy prices and the impact of a stronger dollar on non-energy import prices. However, the fact that core measures of inflation are considerably higher than the headline readings, and have been quite stable in recent months, suggests to me that we are likely to see inflation rise once energy prices stop falling and the dollar stops appreciating—clearly neither trend can persist indefinitely.
Dudley is saying that the stability of core inflation, despite movements in the dollar and oil that have been more persistent than temporary, indicates fairly strong underlying inflationary pressures.
He does, however, include the usual caveat:
Of course, this assumes that the U.S. economy grows sufficiently rapidly so that pressure on available labor and capital resources continues to increase.
That brings us back to the second pillar in the Fed’s mandate, the labor market.
By the Fed’s assessment, excess slack in the labor market has largely disappeared:
And on this point, Dudley pushes back against the notion that the Fed can easily edge the unemployment rate back up should it suddenly become necessary to contain rapidly rising inflation pressures:
A particular risk of late and fast is that the unemployment rate could significantly undershoot the level consistent with price stability. If this occurred, then inflation would likely rise above our objective. At that point, history shows it is very difficult to push the unemployment rate back up just a little bit in order to contain inflation pressures. Looking at the postwar period, whenever the unemployment rate has increased by more than 0.3 to 0.4 percentage points, the economy has always ended up in a full-blown recession with the unemployment rate rising by at least 1.9 percentage points. This is an outcome to avoid, especially given that in an economic downturn the last to be hired are often the first to be fired.
This is a particularly telling insight. Dudley fears that if the unemployment rate falls much further, the Fed will be unable to achieve both maximum sustainable employment and price stability. This will be especially true if oil and the dollar stabilize (or even turn around) and release the downward pressure on inflation.
That’s why Fed officials were willing to begin hiking rates despite weak inflation numbers. They feel their only chance to engineer a smooth transition to sustainable growth is by preventing the unemployment rate from drifting much below 5 percent. Hence the strong jobs numbers drive an underlying hawkishness that continuously bubbles up in speeches and media engagements.
So where does that leave the path of policy? I see five likely scenarios:
- The economy slips into recession, and the December rate hike is yet another in a long line of central banks’ failed efforts to pull up from the zero-bound.
- Financial market conditions stabilize, and the economy slows to a sustainable path of activity such that the unemployment rate stabilizes while inflation remains moderate. This limits the Fed to just one or two more rate hikes later in the year.
- Financial market conditions stabilize, economic activity remains sufficient to push the unemployment rate down further, and inflation remains moderate. This would be similar to the Fed’s baseline scenario in which it hikes rates in four 25-basis-point increments this year.
- Financial market conditions stabilize, economic activity remains sufficient to push the unemployment rate down further, and inflation begins to accelerate. This would push the Fed toward more than 100 basis points in rate hikes this year.
- Financial markets remain choppy in the first half of the year, pushing the Fed into “risk management” mode despite solid labor market activity. The Fed skips the March and April meetings. Officials’ delayed response calms markets and prevents a slowdown in activity, but they feel behind the curve and try to catch up with a steeper pace of hikes late in the year.
Financial market participants at the moment are likely caught somewhere between the first two scenarios.
Scenario five, however, requires serious consideration (and would currently be difficult to differentiate from the first two). It’s consistent with the Fed’s behavior during the Asian financial crisis.
Like now, the U.S. economy faced risks associated with slowing economies abroad as well as capital inflows driving the dollar higher. The Fed then was able to cut rates rather than just delay rate hikes, as is the case now, but found it had to reverse course after the external crisis had passed. Under this scenario, the Fed would find itself exactly where it didn’t want to be—hiking rates at a fairly rapid pace.
Bottom Line: If there was ever any doubt about the “about” of this week’s FOMC meeting, it has long since been eliminated. The Fed will hold policy steady and affirm the faith in its underlying forecast while acknowledging the global and financial risks. This will be interpreted dovishly, probably more so than the policymakers at the central bank would like. Given that I’m in the “no recession” camp, I am wary that the Fed falls into risk management mode now, but at the cost of a faster pace of hikes later. Of course, if you’re in the “recession now” camp, then the game is already over.