Fed Ponders Catchup With Economic Theory Signaling Rates Too Low

Why Are Expectations of a Fed Hike Falling?
  • Policy makers keep option of June rate increase on table
  • Based on Taylor Rule, Fed risk falling behind curve in 2016

When does treading carefully lead to falling behind?

Federal Reserve officials signaled last week that they expect to raise interest rates twice this year, while investors see only one move. If economic theory is any guide, even the central bank’s more hawkish outlook would still leave the target for the benchmark policy rate way too low.

That’s going by a policy rule named after Stanford University economist John Taylor that plugs inflation, output and other data into an equation to calculate the right level of interest. Some lawmakers want to make such a rule binding on the central bank.

The gap between theory and practice arises because officials don’t want to choke off the recovery with rate hikes that may be appropriate on paper, but not digestible in reality. In doing so, they’re taking fire from critics who say low rates are a mistake that could trigger an asset bubble or inflation. Others, including former U.S. Treasury Secretary Lawrence Summers, argue the opposite.

“Is the Fed behind the Taylor Rule? Yes, slightly, and it’s totally reasonable,” said Laura Rosner, senior U.S. economist at BNP Paribas SA in New York. “It’s much cheaper for the Fed to have a little more inflation and to deal with that than to be in a situation where you expand the balance sheet again or cut interest rates into negative territory.”

The Fed is dealing with a complex economic landscape. The jobless rate has fallen to 5 percent, which is near the level many officials view as full employment, yet wage gains remain modest. That holds back inflation that is already below the bank’s 2 percent target, due in part to last year’s oil-price slide and a stronger dollar, while weaker global growth also poses risks.

Fed options to boost growth are limited. Its balance sheet remains five times bigger than it was before the financial crisis and in December it raised rates to a 0.25 percent to 0.5 percent range, before going on hold at the next three meetings of the policy-setting Federal Open Market Committee. With rates still close to zero, officials have argued the economy would pay a smaller price if it generated higher inflation than if it stalled.

Taylor Rule

However, using Taylor’s own 1999 version of his rule as a guide, the Fed should have started its tightening cycle in the third quarter of 2015. Indeed, officials looked to be heading toward a September liftoff before uncertainty about the outlook amid financial-market turmoil persuaded them to delay.

Doubts about global economic prospects subsequently prompted officials to halve the number of rate hikes they expect this year to two, according to quarterly projections released in March. Questions also remain about the amount of slack still in the labor market, with underemployment at 9.8 percent in March.

Plugging the measure for underemployment into the rule predicts that rates should be 1.4 percent by December, compared with the median estimate of Fed officials of 0.875 percent. A version using regular unemployment suggests rates of 1.8 percent by year-end.

“The market turmoil at the beginning of the year left deep scars on the committee which will be slow to heal,” said Aneta Markowska, chief U.S. economist at Societe Generale SA in New York. “The Fed remains unconvinced that we are out of the woods.”

Investors are more pessimistic than officials. While the FOMC on Wednesday left the door open for higher interest rates in June, when new economic forecasts and interest-rate projections will be released, investors aren’t pricing in another hike before December. 

Economists surveyed by Bloomberg are a bit more upbeat and see the target federal funds rate being lifted to a 0.5 percent to 0.75 percent range in June, when the FOMC next meets. Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, is one of them. He said it’s time that the Fed started to tighten.

“A 0.5 percent Fed funds rate is too stimulative for a mature economic expansion,” he said. “Maybe it is just time to get going. A rate hike may just help the economy as it shows Fed officials are confident in the outlook.”

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