Fed Must Look at Soft Data to Justify a Rate Hike
That March rate hike is more than just on the table. It’s the only thing on the menu.
Federal Reserve Chair Janet Yellen sealed the deal on March 3, concluding a busy week of Fed speakers warning that the time for an increase was nigh. Why did central bankers officials need to send such a strong signal? As of just two weeks ago, analysts, including myself, were not seeing the case for a March hike and market probabilities were well below 50 percent.
Fed officials likely do not have a monolithic view on why the time is right to shift gears. Yellen specifically cited diminishing external risks as particularly important. She echoed her fellow Federal Reserve Governor Lael Brainard, who explained more fully the improving outlook abroad and added, on the domestic side, easier financial conditions, improved confidence and expected fiscal stimulus, as contributors to shifting the balance of risks to the outlook.
Note that the divergence between markets and the Fed appears to have been more a matter of increasing confidence in the outlook than one of dramatic change in the outlook itself. The hard data was not sending a strong signal that the Fed should revise upward its forecast (although the February employment report may give such a signal). With the central bank’s basic forecast intact, it seemed reasonable that it could still afford patience.
In recent weeks, however, we have seen an increasing gap between “hard” and “soft” survey data.
For the Fed, however, the combination of the soft data, improving external conditions, the possibility of fiscal stimulus and buoyant financial markets is sufficient to pull forward the next rate hike in the absence of a marked change in the forecast. Everyone on the Open Market Committee can see a greater upside risk for their forecasts. And with the economy hovering near what officials believe to be full employment, a shift in even just the balance of risks is sufficient to pull forward the next rate hike. They fear that further delay will set the stage for a rapid increase in hikes later that ultimately ends in recession.
What does a rate hike in March mean for the rest of the year? If the economic forecasts of FOMC participants remain little changed, then arguably we should expect that the median rate projection of three 25 basis-point rate hikes for 2017 also remains unchanged.
Yet those projections were likely made with an eye toward the downside risks. The easing of those risks might raise the rate projections even if the forecast holds fairly constant. Participants who saw two hikes now see three, for example. With that in mind, I think a March hike means that dots move up to a median projection of four hikes in 2017. Note that four hikes is still arguably gradual compared with past cycles -- and it is consistent with what the Fed expected at the beginning of 2016.
Although the next hike is likely to be accompanied by an increase in policy makers’ median projection of rate hikes for this year, policy is not on a present course. As Yellen reminded us last week:
As in 2015 and 2016, the Committee stands ready to adjust its assessment of the appropriate path for monetary policy if unanticipated developments materially change the economic outlook.
Don’t underestimate the importance of this flexibility. I don’t believe the Fed is making a mistake by bringing forward this rate hike. The financial and economic situations are very different now compared to the end of 2015. Then, the economy looked to be on increasingly shakier ground as the year progressed, with consumption spending softening and the manufacturing sector entering an outright recession.
Financial indicators were not exactly inspiring either. Oil remained mired in the slide that began over a year earlier, the dollar was making fresh highs, stocks were at best moving sideways and at worst setting up for a fresh downturn after a tumultuous summer, and inflation expectations were cratering. Moreover, credit spreads ballooned in 2015, a clear red flag about the health of the economy.
In almost every dimension, the economic and financial environment facing the Fed today is almost the mirror image of that in December 2015.
To this day, the Fed’s decision to hike in 2015 remains a mystery. There was no pressing reason to hike, yet it did anyway. The only thing that kept it from being a mistake was that the Fed quickly realized that it needed to pull back on expectations that 2016 would see four rate hikes.
Indeed, it is reasonable to think of the December 2015 hike as an aborted attempt to lift off from the zero bound, while the true tightening cycle began in December 2016. The lesson for market participants is that even if the Fed was making a mistake now, 25 basis points is a correctable mistake.
The Fed’s patience appears to have come to an end. Officials are prepared to hike rates again in March on the back of rising upside risks to their forecast. Whereas 2016 was yet another year that the Fed needed to move toward the markets, this could finally be the year that markets move toward the Fed.
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