The Fed's New Chapter Will Be Written in Dollar-Denominated Oil
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.
The Federal Reserve is set to raise interest rates this week for the first time since 2006.
The final days of the zero interest-rate policy known as ZIRP are upon us; the end is here.
But the end of ZIRP is the beginning of a new chapter of monetary policy. This chapter will tell the story of the Federal Reserve’s efforts to normalize policy, and that particular tale has yet to be written. You can, however, expect Fed Chair Janet Yellen to emphasize “gradually” and “data dependent” as she pens the first few lines of the narrative at this week’s press conference.
Policymakers have clearly signaled that the U.S. central bank will raise the target range for the Federal Funds rate by 25 basis points this week. To be sure, this does not mean that the U.S. economy is without its warts. The labor market is not quite at full employment and the external environment is dragging on growth in general (and manufacturing in particular), while inflation remains stubbornly below the 2 percent target. Yellen & Co. are confident that these issues are transitory in nature. Here's Yellen’s summary of her outlook, from her December speech:
… I anticipate continued economic growth at a moderate pace that will be sufficient to generate additional increases in employment, further reductions in the remaining margins of labor market slack, and a rise in inflation to our 2 percent objective. I expect that the fundamental factors supporting domestic spending that I have enumerated today will continue to do so, while the drag from some of the factors that have been weighing on economic growth should begin to lessen next year. Although the economic outlook, as always, is uncertain, I currently see the risks to the outlook for economic activity and the labor market as very close to balanced.
Although there exists a policy asymmetry, as the Fed is less able to react to negative shocks when interest rates are low, the lags in the monetary policy process argue for tightening financial conditions sooner, rather than later, if the central bank wants to avoid steep rate hikes in the months ahead. Hence, as long as policymakers can expect the labor market improvement to continue, the path is clear to raise interest rates. And any doubt about the health of the labor market was laid to rest with the most recent blockbuster employment report.
What comes next? The statement and the subsequent Yellen press conference will emphasize four main points:
1. Policy remains accommodative.
Yellen will discourage the idea that this rate hike implies that policy is tighter; she would prefer the term “less accommodative.” As she said in her speech, “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
2. Further tightening will be done at a gradual pace.
Yellen has made no secret that this is a key motivation for beginning the cycle: “Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals.” This may be reinforced in the Fed's "Summary of Economic Projections" by at-best-modest downward revisions to the interest rate projections, a lower estimate for longer-run unemployment, and a slower return of core inflation to target.
3. Implementation of “gradual” will be data-dependent.
As it stands, “gradual” will be defined by the dot plot of expected interest rates in the Summary of Economic Projections. The outcome, however, will be determined by continued progress toward the Fed’s goals. Policymakers will emphasize that faster than expected progress will prompt a more rapid pace of future rate hikes and vice-versa.
4. Policy is not on a pre-set course.
A 25 basis point move this week does not mean 25bps at the next meeting, or even the meeting after that. And a 25bps move does not mean that the next move must be 25bps. In theory, a “gradual” 100bps rise over the next year could come in combinations of 25bps and 50bps. Policymakers do not want to feel boxed in by market expectations during the normalization process, and this will be reflected in their communications. The lack of certainty will probably frustrate market participants.
Will any of Yellen’s colleagues dissent?
Three names are at the top of the potential “dissent list": Chicago Federal Reserve President Charles Evans and governors Lael Brainard and Daniel Tarullo. My bet, however, is that none will dissent during what is ultimately a sensitive time for the central bank. I think all want ultimately to find a way to support Yellen. They will find sufficient for their support her reassurance that future policy moves will be very careful and deliberate. Plenty of battles will remain to be fought, however. Brainard has already started campaigning to leave the reinvestment policies of the Fed's vast U.S. Treasury portfolios on hold until rates are high enough to provide a cushion in the next downturn.
I have my eye on the dollar and oil as key factors in the path of subsequent rate hikes.
We know the Fed anticipates that the disinflationary impact of these factors will lessen as the year progresses. Back to Yellen:
Regarding U.S. inflation, I anticipate that the drag from the large declines in prices for crude oil and imports over the past year and a half will diminish next year. With less downward pressure on inflation from these factors and some upward pressure from a further tightening in U.S. labor and product markets, I expect inflation to move up to the FOMC's 2 percent objective over the next few years.
Meeting this expectation is an important litmus test for further rate hikes.
Yellen is concerned that persistently low inflation will eventually drag inflation expectations lower, increasing the challenge of achieving the Fed’s 2 percent target. Hence:
Given the persistent shortfall in inflation from our 2 percent objective, the Committee will, of course, carefully monitor actual progress toward our inflation goal as we make decisions over time on the appropriate path for the federal funds rate.
I expect that, if the U.S. dollar and oil continue to fluctuate in their recent ranges and all else remains constant, their impact on inflation will wane, giving the Fed room to tighten gradually. If the policy divergence (note also the growing pressure on the Chinese yuan) and oil glut stories gain further strength, disinflationary effects will intensify, pressuring the Fed to slow the pace of future hikes. "Gradual" would thus become even more gradual. But will the dollar move higher? Many commentators have noted the tendency of the dollar to fall after the Fed begins hiking rates. And a fall in the dollar might just pull oil higher. Note that the recent inverse moves were dramatic:
The pricing of commodities in dollars is the standard explanation for this negative correlation. Such an outcome would give the Fed room to hike at a faster pace than they anticipate. In that case, "gradual" would become less gradual.
Bottom Line: One chapter ends, another begins. This one begins slowly, as persistently low inflation leaves the Fed uneasy in beginning the rate-hike cycle. You should watch the forces wielding a transitory impact on inflation, especially the dollar. The Fed sure will. And remember that this chapter is not just about raising rates. It’s also about the effectiveness of the Fed’s tools for managing higher rates, as well as the reduction (or not) of the balance sheet. Not to be forgotten, it concerns the economy's ability to handle higher rates. This 25bps is just the beginning of this story.