It's Way Too Early for the Fed to Consider a March Rate Increase
The countdown to the Federal Reserve's next policy meeting in mid-March has begun, and so have the pleadings of some central bank officials desperately trying to suggest the meeting is “live.” Market participants remain wary -- and rightfully so -- that the Fed might pull the trigger on another interest-rate increase before June.
Unless policy makers are truly ready for a preemptive hike -- and Fed Chair Janet Yellen has a chance to send that signal when she testifies before Congress this week -- they would be wise to dial back their March talk. The data are on the market’s side.
The median rate forecast in the December 2016 “Summary of Economic Projections” anticipates three 25-basis-point increases this year. Fed speakers generally appear comfortable with this number. Even Yellen, often considered to be on the dovish side of the table, acknowledged that she shared this forecast.
With the year less than two months old, we don’t have enough data to confirm or deny this forecast. We do have enough data to question the timing of the next hike. And that data suggest that March isn't likely. The January employment report, while showing a solid 227,000 gain in nonfarm payrolls, also revealed an uptick in unemployment to 4.8 percent. That is actually good news. It means the Fed is underestimating the rate of labor-force growth. The economy can run hotter for longer than the Fed anticipated and justifies a continued gradual approach.
In addition, the Fed was counting on further unemployment declines (to 4.5 percent by the end of the year) to place some much needed upward pressure on inflation. Core inflation, as measured by the Fed’s preferred price index, was running at just 1 percent on an annualized basis in the final three months of 2016, compared with the central bank's target of 2 percent, raising some questions about the Fed’s inflation forecast.
This combination of data seems to justify the Fed’s current “go slow” approach. It doesn't scream for a rate hike in March. And with current odds of a boost hovering below 30 percent, that’s the signal markets are receiving, too.
Some Fed policy makers don’t appear to like these odds. I suspect they don’t like the markets to preordain the outcome of meetings when they themselves don’t believe they know the outcome. Officials such as San Francisco Fed President John Williams and Philadelphia Fed President Patrick Harper both have said recently that March remains open for a possible rate move.
Sure, it’s open because there will be a meeting and there will be talking. But market participants are matching the data to the Fed’s reaction function and concluding that 1) the Fed isn't behind the curve, 2) if anything, the Fed is in jeopardy of falling short of its forecast, 3) there is no pressing reason for a preemptive move, especially given that 4) the Fed still has plenty of opportunities to raise rates later this year, and 5) the quantity of incoming data between now and the March meeting isn't likely to be sufficient to overturn points 1 through 4.
Fed officials need to be very careful in their pronouncements that March is still “live.” Given current data, a March move requires a fairly significant policy shift by escalating the importance of a preemptive rate hike. Unless Fed officials are prepared to make such a policy shift, they risk undermining their own communications strategy.
Yellen will most likely stick to the basic story this week: Labor markets continue to strengthen, inflation is low but still expected to drift toward target, and the outlook justifies further rate increases, but the timing is data-dependent. March, like all meetings, is a real meeting, but I doubt she will attempt to emphasize the possibility of a rate hike in March. And she will neither set a timeline for balance sheet normalization nor give any more insight into her thinking on fiscal policy other than hypothetical responses to hypothetical tax and spending plans. I suspect her primary focus will instead be on deterring efforts to rein in the Fed’s independence.
The bottom line is that market participants are getting the Fed’s story pretty much right. But when Fed officials make a case for March when the data says otherwise, they do little more than muddle their communications strategy. Best to let the data do the talking when it comes to the timing of the next hike. If the data shifts, market participants will shift with it.
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