It’s not just a new year; it’s a new era for monetary policy. Or is it? The Federal Reserve ended seven years of near-zero interest rates, but Fed thinking has changed little. And while the Federal Open Market Committee (FOMC) removed some policy uncertainty, it scarcely removed it.
With lingering concerns about subpar growth, labor market slack and below-target inflation, the Fed remains in near-crisis mode with rates far below even a much-reduced notion of normal, and with an enormous balance sheet it has no intention of shrinking anytime soon.
When and by how much rates will rise further is anyone’s guess. After the FOMC unanimously raised rates 25 basis points in December, Yellen stressed the move was a sign of confidence. She also portrayed the much-delayed, modest hike as a cautionary recognition of the lags with which monetary policy works.
“It has been a long time since the Federal Reserve has raised interest rates, and it’s prudent to be able to watch what the impact is on financial conditions and spending in the economy, and moving in a timely fashion enables us to do this,” she said. “Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly at some point to keep the economy from overheating and inflation from significantly overshooting our objective.” She added that an abrupt tightening could push the economy into recession.
While the FOMC was confident enough about achieving full employment and 2% inflation, its policy statement and Yellen repeatedly emphasized further rate hikes will be gradual. She also stressed the FOMC’s willingness to adjust policy if its assumption that inflation will rise to the 2% target proves wrong.
And don’t forget that, while it began normalizing rates, the Fed made no move to normalize its $4.5 trillion balance sheet. It will prevent any shrinkage by reinvesting principal payments from agency debt and mortgage-backed securities and rolling over maturing Treasury securities until rate hikes are “well underway.”
The FOMC thereby not only maintained downward pressure on long-term rates, it gave itself room to cut short-term rates if needed. Yellen explained, “One factor that we have talked about is the desirability of having some scope to respond to an adverse shock to the economy by lowering the federal funds rate.”
It could be quite a while before the Fed shrinks its balance sheet, and it may never return to pre-crisis levels. Altogether, one might conclude Yellen and Co. believe what an obstinately sluggish, disinflationary economy needs is a little, ahem, tough dove.
Supporting the gradualist theme, though not as much as many had hoped, is the latest dot plot — the
17 FOMC participants’ assessments of appropriate funds rates over the next three years. Their 1.375% median projection for the end of 2016 implies four rate hikes, but that’s more than a full percentage point lower than projected a year earlier and 50 basis points above where Fed Fund futures project rates.
Projections for 2017-18 were revised down modestly with the funds rate ending 2018 at 3.3%. That compares to a longer-run funds rate estimate of 3.5%.
The dots might seem to imply rate hikes at each of the quarterly meetings where Yellen holds a press conference and the FOMC releases revised economic and funds rate projections. But don’t count on it. The actual pace could differ considerably and may not be predictable. Yellen often has said the Fed is going to be “data dependent,” but also has said she wants to avoid being “mechanical,” as in 2004-06, when the FOMC raised the funds rate at 17 straight meetings.
“We will try to avoid that,” Yellen said. “I want to emphasize that gradual does not mean mechanical, evenly timed, equally sized, interest rate changes....”
“My guess is that the economy will progress in a manner that is not sufficiently even that we will decide to make evenly spaced hikes,” she added. “I recognize we want to do what is appropriate, and I recognize that is a danger. But I want to assure you that we will be data dependent, as the outlook evolves, we will respond appropriately.”
What will it take for the FOMC to make its second move? Yellen may want to see inflation rise to 2%, but said, “It doesn’t mean that we need to see inflation reach 2% before moving again.”
She said, “We have expectations for how inflation will behave, and were we to find that the underlying theory is not bearing out, and that it doesn’t look like the shortfall is transitory and disappearing with tighter labor markets, that would certainly give us pause.”
If actual rate hikes mirror the dots it will be strictly accidental.