WHAT SHOULD THE FED DO WHEN NO ONE LISTENS? / THE WALL STREET JOURNAL

What Should the Fed Do When No One Listens?

The Federal Reserve is tightening but financial conditions are getting looser. For the central bank, that presents a problema

By Justin Lahart



EASY GOING
The Federal Reserve Bank of Chicago´s financial condition index

Note: Values below zero indicates conditions are looser than average

Investors are ignoring the Federal Reserve. That could make the Fed’s job more complicated.

Fed policy makers concluded their first meeting on the year Wednesday, and while they kept rates on hold, they also provided an upbeat outlook on the economy that made clear that they expect to raise rates at their next meeting in March.

The Fed raised its target range on overnight rates three times last year, and projects it will raise rates another three times this year. But the Fed’s moves don’t seem to be putting up much of a headwind. Stocks are richly valued, and corporate bond yields are extremely low versus comparable Treasurys. On Wednesday, the Federal Reserve Bank of Chicago reported that its financial-conditions index has dropped to its easiest level since 1993.

With newly enacted tax cuts pumping fresh funds into the economy, and President Donald Trump on Tuesday calling for a $1.5 trillion infrastructure plan, financial conditions may get easier. That goes against the Fed’s goal of making them tighter.

For the Fed, the situation is both unsettling and familiar. When the central bank raised its overnight target rate from 1% in mid-2004 to 5.25% in mid-2006, financial conditions remained remarkably easy. There were plenty of reasons why, including money gushing into the U.S. from overseas, aggressive lending practices and mistaken beliefs about the risks inherent in many financial products.

The Federal Reserve raised its target range on overnight rates three times last year, and projects it will raise rates another three times this year Photo: Andrew Harrer/Bloomberg News        


But the Fed also played a role. Not only was it slow to start raising rates following the mild 2001 recession, but when it did start raising them it did so exactly a quarter point at each meeting.

Investors felt they knew precisely where rates would be at any given time, diminishing perceived risks. Asset prices—particularly those tied to housing—ran unchecked, leading to the financial crisis.

The Fed’s main concerns are jobs and inflation. Right now its rate projections are based on an expectation that unemployment won’t fall that much further and that inflation drifts up close to its 2% target by year-end.

But the Fed meets its goals by tightening or loosening financial conditions using interest rates.

If raising rates doesn’t tighten conditions sufficiently, the Fed will raise them more. And after what happened the last time the Fed raised rates but conditions stayed easy, the central bank might decide it needs to make its rate increases a little more jarring.