The Fed Gave Itself a Safety Net
The Federal Reserve concluded its March meeting with a widely anticipated 25 basis-point interest-rate increase. But it was a dovish hike. While officials coalesced further around their projection of three more for 2017, the median did not rise to four as some, including myself, had expected. This was entirely a risk-management move: The Fed saw a strong enough economy to pull forward a rate hike, but not enough actual change to warrant a faster pace of increases.
Not that four hikes is ruled out; neither is two. If you are fairly pessimistic on the outlook, then you will lean toward expecting two hikes over three this year. If you are more optimistic, like I am, you lean in the other direction and the risk is four increases rather than three. In either case, markets should take solace in the fact that with target rates in the 75 to 100 basis-point range, the U.S. economy gets back what it hasn’t had in a long time -- a monetary-policy safety net.
After this week’s Federal Open Market Committee meeting, rates are 75 basis points above the zero bound. While not sufficient to respond to a full-blown recession, 75 basis points proved sufficient to respond to unexpected negative shocks during the 1990s without having to resort to extraordinary measures such as quantitative easing. Recall that the Fed reacted to a softening economy with 75 basis points of cuts in 1995 and 1996, and responded similarly to the Asian financial crisis in 1998.
In both cases, the Fed easing proved enough to prevent the economy from slipping into recession. In short, if past experience is any guide, 75 basis points provides a reasonable safety net if the Fed needs to address a modest shock to the economy. To be sure, this falls well short of the firepower required in the face of a full-blown recession. But having some room now should give investors a little more comfort that the Fed can respond to unexpected weakness. Moreover, that room also provides a greater opportunity to begin the process of unwinding the balance sheet, something policy makers continue to ponder but have not decided when to begin.
Altogether, Fed Chair Janet Yellen can take a well-deserved victory lap. Stock and bond markets rallied strongly, while the dollar weakened. The Fed is very close to meeting its mandates while continuing the process of normalizing rate policy. They have even opened up some breathing room in case the Fed needs to reverse course. And, most importantly, they have been able to accomplish all this while maintaining a moderate pace of tightening that has yet to endanger the recovery. For now, it looks like the Fed continues to do more things right than wrong.
The forecasts as presented in the Fed’s Summary of Economic Projections were little changed. Still, a couple of points are notable. The core inflation projection edged up 0.1 percentage point, showing the Fed is becoming more confident of meeting its inflation target by the end of this year. Beware that as the target approaches, we are likely to see more occurrences of idiosyncratic inflation readings above target.
Keeping this in mind, consider the slight change in the FOMC statement that highlighted the symmetric nature of the inflation target. I interpret this to be a reminder that the Fed does not intend to overreact to small overshoots as long as they are modest. A rise in the near-term inflation forecast, however, would normally put some upward pressure on the median projected rate increase for the year.
That brings me to the second notable amendment. The Fed’s longer-run estimate of the unemployment rate fell even though the unemployment projection remained unchanged. Hence, the expected undershooting of the unemployment rate decreased, which would tend to place downward pressure on rate projections. This cancelled out the higher inflation forecast.
The average dot, or rate projection, for 2017 shifted up, but not the median. Nine policy makers now expect three rate hikes in 2017, compared with six at the December meeting. Doves became less dovish, but the median policy maker remained steadfast in their 2017 forecast. Ultimately, we need to see more evidence of accelerating growth before the median edges up another notch. That could happen at the June meeting, the most likely time for another rate hike, but barring a fairly rapid shift in the tenor of the data, I doubt we will see a May hike.
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