Fed Doves Won't Be Able to Rule the Roost Forever
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.
How long can doves at the Federal Reserve stand their ground?
The fight within the U.S. central bank continues at this week's Federal Open Market Committee (FOMC) meeting as both hawks and doves jockey for dominant position. This battle will go to the doves; the Fed is not expected to raise its interest rate target just yet. Both the hawks and the doves know this. Both camps also know that this meeting is about laying down markers for the September meeting. And while the doves have the upper hand this month, the current flow of data will increasingly place them on the defensive as the second half of the year progresses.
In a key paragraph from the minutes of the June 2016 FOMC meeting, the participants set what appear to be straightforward guides to the timing of the next rate hike:
"Most participants judged that, in the absence of significant economic or financial shocks, raising the target range for the federal funds rate would be appropriate if incoming information confirmed that economic growth had picked up, that job gains were continuing at a pace sufficient to sustain progress toward the Committee's maximum-employment objective, and that inflation was likely to rise to 2 percent over the medium term."
On the surface, there are clear, objective standards for policymakers to act. Indeed, it is arguably the case that these standards justify a rate hike at this meeting. Financial markets have recovered from Brexit with U.S. equities since hitting all-time highs. Economic growth has picked up, as indicated by the Atlanta Federal Reserve GDPNow indicator:
A spike in job growth in June followed the weak May report:
Still low initial unemployment claims also indicate that the May jobs slowdown was only an aberration:
And recent inflation reports suggest the Fed is on track to meeting its 2 percent target:
The Fed's preferred measure of inflation registered about 2 percent or greater on an annualized basis in four of the last five readings. At this rate, it is reasonable to expect year-over-year core inflation to hit the target 2 percent by the end of 2016.
Case closed, right? Time for a rate hike, correct? Not so fast. These indicators are less objective and more subjective than first meets the eyes. To be sure, Fed hawks see room for a rate hike sooner than later:
"Some participants viewed a broad range of labor market indicators as well as the recent firming in wages as consistent with a high level of labor utilization. They also pointed out that core inflation had begun to move up and that the transitory factors that had been holding down headline inflation were receding. Several of these participants expressed concern that a delay in resuming further gradual increases in the federal funds rate would increase the risks to financial stability or would raise the potential for overshooting the Committee's objectives; such an overshooting might require a rapid removal of policy accommodation at some point in the future, which could entail significant risks for U.S. financial markets and the economy."
It's relatively easy to argue that Fed hawks read incoming data since the June meeting as reason to hike now. Delay only increases the odds of overshooting the inflation target and undermining financial stability.
The doves, however, will read the data much more cautiously:
"However, some other participants were uncertain whether economic conditions would soon warrant an increase in the target range for the federal funds rate. Several of them noted downside risks to the outlook for growth in economic activity and for further improvement in labor market conditions, including the possibility that the sharp slowdown in employment gains and the continued weakness in business fixed investment signaled a downshift in economic growth, as well as the potential for global economic or financial shocks. Moreover, several of them worried about the declines in measures of inflation compensation and in some survey-based measures of inflation expectations and suggested that monetary policy may need to remain accommodative for some time in order to move inflation closer to 2 percent on a sustained basis. A few pointed out that with inflation likely to remain low for some time and to rise only gradually, maintaining an accommodative stance of policy could extend the strengthening of the labor market. In addition, several participants observed that because short-term interest rates were still near zero, monetary policy could, if necessary, respond more effectively to surprisingly strong inflationary pressures in the future than to a weakening in the labor market and falling inflation."
To pull the doves to the rate hike side of the equation requires further evidence that labor markets remain firm, signs that business investment is turning up, and a pattern of sustained inflation near the Fed's target to compensate for softness of inflation expectations. Even better would be that inflation expectations actually firm up. And even if all of those conditions are met, they will still argue that asymmetric risks justify delaying rate hikes.
In short, while in general FOMC participants agree on the broad conditions necessary to justify a rate hike, they split into two very different camps when it comes to actually interpreting those conditions. The dovish camp currently has more weight among voting members on the FOMC. Hence, the Fed remains in a holding pattern, taking a pass on rate hikes for the fifth time since they dipped their toes in the water last December.
But what about the rest of the year? Assuming the data evolves along its current path, the doves will find it increasingly difficult to delay additional rate hikes under the current policy framework. They will need to lean increasingly on their asymmetric risk argument to stave off a rate hike in September. And even if they can hold the line in September, it seems unlikely under these circumstances that they could do so again in December. So I continue to believe the stage is set for a minimum of one, and possibly two, rate hikes this year.
A key part of this analysis, however, is that the Fed remains under the current policy framework. That framework includes a focus on interest rate policy as the first element in the Fed's normalization strategy. This framework won't hold together if long bond yields remain stubbornly low. With the yield curve flattening relentlessly and the 10-year U.S. Treasury yields mired below 2 percent, it seems all too easy to see the Fed further flattening or even inverting the yield curve with only one or two rate hikes. As Federal Reserve Governor Daniel Tarullo recently warned, this means that further rate hikes will exacerbate, not ease, financial stability concerns.
If the Fed can't chase longer-term yields higher, they are effectively stuck between a rock and a hard place under the current strategy. Economic conditions might indicate tighter policy, but financial conditions do not allow for higher short-term rates. If monetary policymakers see a need for tighter policy, but cannot lift the yield curve rather than flatten it via raising the federal funds target, they need to reconsider the wisdom of their policy framework. They should at least be debating the wisdom of hiking rates rather utilizing the balance sheet – changing the composition and size of the Fed's asset holdings – as a means to tighten policy. They may not have any choice but to have this debate by the end of this year.
Bottom Line: Despite economic data that may on the surface make the case for an interest rate hike, the Fed doves are holding their ground. The devil is in the details. What might justify a hike to one FOMC participant fails to sway another concerned with persistently low inflation and asymmetric policy risk. With the doves still dominating the policy discussion, the Fed will pass on raising rates this week. But a continuation of recent data trends will increasingly put the doves on the defensive. Absent a strategy chance, the stage is being set for Fed hawks to squeeze out one if not two hikes this year.