The Fed ruins summer
America’s central bank picks a poor time to get hawkish
THE members of the Federal Reserve's monetary-policy making committee have been desperate to hike rates, often, for most of the past year. They were keen to begin hiking in September, but were put off when market volatility threatened to undermine the American recovery. In December they managed to get the first increase on the books, and committee members were feeling cocky as 2016 began; Stanley Fischer, the vice-chairman, proclaimed that it would be a four-hike year. Instead, markets spent the first two months of the year in a near panic, and here we are in mid-May with just the one, December rise behind us.
But the Fed is feeling good about the state of the state of the economy and is ready to give higher rates another chance. Over the last few weeks, every Fed official to wander within range of a microphone warned that more rate hikes might be coming sooner than many people anticipate. And yesterday the Fed published minutes from its April meeting which were revealing: "Most participants judged that if incoming data were consistent with economic growth picking up...then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June."
The committee members in favour of hiking make a few key arguments. Many of them reckon that labour-market slack is just about used up, and wages will soon rise at a much faster clip. Combined with higher oil prices, that should push up inflation, possibly above the Fed's target, possibly high enough that the Fed would need to rush through a lot of rate hikes to regain control, risking recovery in the process. Some argue that rates are excessively low, and are encouraging risky financial behaviour, sowing the seeds of future crises. Amusingly, some think that, "further postponement of action to raise the federal funds rate might confuse the public...and potentially erode the Committee’s credibility." Amusing, as the one thing the committee can credibly generate is confusion.
There is a global glut of investable savings too, which has pushed down long-run real interest rates around the world. That, in turn, constrains central banks, which cannot lift their rates very high without attracting a deflationary flood of capital. Over the last thirty years, central banks have found it much easier to push inflation down than up.
And it is worth focusing on the fact that the Fed does not have cause to try to push inflation down. Its preferred measure of inflation continues to run below the Fed's 2% target, as it has for the last four years. Somehow the Fed seems not to worry about what effect that might have on its credibility. All that undershooting has depressed market-based measures of inflation expectations, which suggest the public expects inflation to remain below target for some time. If the Fed's goal is to hit the 2% target in expectation, or on average, or most of the time, or every once in a while, or ever again, it might consider holding off on another rate rise until the magical 2% figure is reached. You know, just to make sure it can be done.
But the single biggest, overwhelming, really important reason not to rush this is the asymmetry of risks facing the central bank. Actually, the Fed's economic staff explains this well; from the minutes:
The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks. In addition, while there had been recent improvements in global financial and economic conditions, downside risks to the forecast from developments abroad, though smaller, remained. Consistent with the downside risk to aggregate demand, the staff viewed the risks to its outlook for the unemployment rate as skewed to the upside.The Fed has unlimited room to raise interest rates. It doesn't want to have to jack up rates dramatically and quickly in response to surging inflation, but if it had to it could. It has almost no room to reduce rates. If an unexpected stretch of economic weakness comes along (and such a stretch is far more likely to come along than is dangerously high inflation) then the Fed is in a very serious bind indeed. Even if it is up for cutting rates as deep into negative territory as other central banks have dared to, that still leaves it very little room to cut. It has its unconventional tools available, but the Fed has proven none too anxious to roll them out in the past. If wages were growing as fast as they typically do during a healthy expansion, and if inflation had finally made its way back to and above target, then the Fed could be fairly confident that a rate increase wouldn't unexpectedly leave the central bank face to face with deflation and with few tools to respond.
But the economy isn't there yet. Hiking now is a leap off a cliff in a fog; one could always wait and jump later once conditions are clearer, but having jumped blindly one cannot reverse course if the expected ledge isn't where one thought it would be.
The Fed's incautious behaviour is especially worrying given the state of the world. Not only would it struggle to restore growth if it turned out to have overestimated the strength of the American recovery; it would also push the world's largest economy into a slump at a moment of serious global economic and political vulnerability. The state of the world has been better.
The Brazilian state and economy are looking dangerously weak. China continues to accumulate debt at a pace that cannot go on for much longer. Britain will vote on whether to leave the EU just a few days after the June Fed meeting; Austria is about to elect a far-right president—just the latest far-right leader to enjoy political success on the continent. This might not be quite the right moment to take a relaxed attitude about the possibility of inducing an American slump.
What is most unfortunate, however, is that committee members seem not to realise the effect their statements send. Yesterday, before the minutes were released, the estimated probability of a rate hike in June (derived from futures prices) was about 6%. This morning, that probability rose above 30%.
With that shift in expectations, all the other market prices one would expect to move have moved.
Emerging-market currencies began falling against the dollar, equities are off, and so on. The market ructions will deliver much the same effect an actual rate hike would. Ironically, the market wobbles might be enough to dissuade the Fed from pulling the trigger when the June meeting rolls around. But a lot of harm will already have been done.