The Fed's Evolving Approach to Raising Rates
With May’s jobs report just one of several signs indicating that the U.S. economy has hit a soft patch, the Federal Reserve may have reasons to be cautious and refrain from increasing interest rates when the Federal Open Market Committee meets next week. Indeed, that is what the Fed would have done in past years.
But U.S. monetary policy has been evolving and -- unlike the European Central Bank -- the Fed is no longer an institution looking for an excuse not to gradually tighten its stance. As such, the Fed will not only raise rates next week, but it will also continue to signal to markets its baseline expectations of another interest rate action later this year -- and, perhaps, the broad outlines of its approach to slowly shrinking its $4.5 trillion balance sheet.
Disappointing job creation and sluggish wages have now joined other “hard data” slippages that suggest the U.S. economy is again having trouble sustaining an annual growth rate firmly above 2 percent. In the process, the wedge has grown between economic reality on the ground and what both sentiment indicators and the stock market are signaling.
Meanwhile, with Washington continually distracted by talk of one investigation or another, prospects have dimmed that Congress will work with the Donald Trump administration on the timely implementation of its pro-growth policies (tax reform, infrastructure and deregulation), notwithstanding Republican majorities in both the Senate and the House of Representatives. With that, the interest rate on 10-year Treasury bonds slipped below 2.20 percent this week, and the dollar has weakened to levels last seen in November.
It’s deja vu for central bank observers. Most of these elements surfaced several times in the aftermath of the 2008 global financial crisis; they fueled a prolonged period of unusually dovish monetary policy that saw the Fed repeatedly walk away from prior -- and more hawkish -- guidance on interest rates.
Such reaction reflected both offensive and defensive strategies.
With polarization on Capitol Hill precluding pro-growth reforms and a more active fiscal policy, the Fed became the only game in town in terms of significant measures to support growth -- this despite growing recognition, both inside and outside the central bank, that the best its available tools could do is buy time for politicians to get their act together. And with the valuation of risk assets decoupled from fundamentals, the Fed worried about the risk that a premature tightening could destabilize financial markets, thereby undermining household and corporate confidence and creating yet another headwind to growth.
With time, however, Fed officials recognized that such an approach was not without its own risks -- economic, financial, institutional and political. As such, officials became more convinced of the need to advance a gradual normalization of monetary policy. You need only look at the run-up to the March Fed meeting for a vivid illustration of the Fed’s modified policy approach.
With concerns about the economy’s growth leading markets to attach a probability of less than 30 percent for a Fed hike just two weeks before that policy decision, officials went out of their way to guide rate expectations higher. An effort initiated by two presidents of regional Feds culminated in quite deterministic guidance from Chair Janet Yellen and Vice Chair Stanley Fischer. Consequently, the implied market probability soared to more than 90 percent, allowing the Fed to deliver an orderly interest rate action, with solid guidance for two more in 2017.
Similarly, in the run-up to the upcoming meeting, several Fed officials have reiterated this forward policy guidance, notwithstanding the economic soft patch. Indeed, with markets expecting a rate hike, neither Yellen nor Fischer have seen the need to manage expectations this time around.
To advance this evolving policy shift, the Fed needs to accompany its rate hike next week with a reaffirmation of the likelihood of a third hike this year and provide the initial broad outlines of how it will start shrinking its balance sheet in 2018. And that is what it will most likely do. This is not to say that officials are hellbent on tightening monetary policy regardless of how the economy is doing. But nowadays, they need to see a significant economic slowdown before changing the policy of an entity that no longer looks for excuses to remain ultra-dovish.
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