Delaying Rate Hikes Averted Bigger Slowdown, Fed Economists Say

How Fed Rate Hike Messaging Impacts the Economy
  • Drop in expected increases boosted GDP for several quarters
  • Fed communications helped offset tighter credit spreads

The U.S. Federal Reserve’s decisions to delay interest-rate hikes helped cushion the economic shocks caused by rapidly rising borrowing costs for U.S. companies from late last year through early 2016, according to economists at the New York Fed.

“By maintaining the federal funds rate lower, the FOMC managed to substantially offset the effect of tightening financial conditions on the economy,” the authors, referring to the rate-setting Federal Open Market Committee, wrote in a blog post on the bank’s website on Wednesday.

Downgrades to the outlook for foreign economic growth and the deterioration of credit quality in the U.S. energy sector from the slump in oil prices last year led to wider credit spreads, Marco Del Negro, Marc Giannoni and Micah Smith said in the post. Tighter financial conditions helped bring economic growth to its slowest pace in two years during the first quarter of 2016, though it would have been worse had the Fed not adopted greater caution toward rate hikes, they said.

The researchers used a model to determine that the lower expected path of the central bank’s benchmark rate priced into markets “managed to boost GDP growth by more than 1 percentage point for several quarters, essentially offsetting the negative effect of the tightening in financial conditions.”

Rate Path

In December, when the FOMC raised the federal funds rate for the first time in nearly a decade, the median projection of the 17 participants called for four rate increases in 2016. In mid-March, updated projections showed the median participant projected only two hikes this year, after investors had reduced the expected path of tightening priced into markets.

Fed Chair Janet Yellen, during a speech in New York on March 29, cited reduced expectations for rate increases as an “automatic stabilizer” that supported the economy.

“FOMC communication early in 2016 was likely an important factor in the re-normalization of financial conditions, although this is not well captured by the model," the New York Fed researchers said. “Thanks to this reversal in credit spreads, the restrictive effect on GDP growth in the current quarter is expected to be much more modest than it would otherwise have been.”

A data tracker maintained by the Atlanta Fed projected on May 17 that the U.S. economy grew at a 2.5 percent annualized rate in the second quarter. That compares with the Commerce Department’s initial estimate of 0.5 percent annualized growth in the first quarter.

Recently several Fed officials have suggested that investors were underestimating how many times the Fed would raise rates this year. The warnings caused investors to increase their bets on a rate hike at either of the Fed’s next meetings in June and July.

“Some tightening of financial conditions is completely appropriate,” New York Fed President William Dudley said last week. “That’s sort of the purpose of tightening monetary policy.”

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