Weening a country, or market, off easy money is tricky, even when it’s done slowly, as the Federal Reserve is doing. The removal of monetary accommodation is not made any easier by protectionist threats and counter threats that complicate the macroeconomic mix, roil markets and tighten financial conditions.
Despite near hysteria at times over Fed actions, the markets seemed to be coming to terms with rising interest rates when President Trump’s tariff announcements triggered trade war anxieties. Needless to say, there’s nothing the Fed can do about trade policy, although new Fed Chairman Jerome Powell says that trade has become “a more prominent risk” to the downside.
More expansive fiscal policies pose offsetting upside risks, but Fed officials are restrained in their assumptions of how much tax cuts and increased federal spending change the economic outlook. In March they revised up their GDP projections by two-tenths for this year and three-tenths for next year before growth is expected to recede to 2%.
It’s hard to see why markets should be so alarmed about interest rates at this juncture. It took seven years after the financial crisis for the Fed to stop holding the federal funds rate near zero. In 2015 and 2016, that benchmark short-term rate was raised a total of 50 basis points, while a balance sheet bloated by three rounds of heavy bond buying was left untouched. Finally, in 2017, the Fed got more serious about “normalizing” policy — raising the funds rate three times by 75 basis points. Not until October 2017 did the Fed at last start to shrink the balance sheet and then just passively by progressively limiting securities reinvestments and rollovers.
By the time Powell chaired his first Federal Open Market Committee meeting in March, the funds rate was still nestling in a 1.25-1.50% range — barely half the FOMC’s estimated longer run “neutral” rate.
When the FOMC announced a sixth rate hike on March 21, it was merely taking “another step in the process of gradually scaling back monetary policy accommodation as the economic expansion continues,” Powell said in his first press conference. Yet. there was talk that the Fed’s rate-setting body had become more aggressive, even though they retained their projection of three moves in 2018 and only modestly increased the number of anticipated rate hikes in the next two years. The median funds rate for the end of 2020 was lifted from 3.1% to 3.4%. Some aggressiveness: A net 30 basis points of tightening over three years.
And there’s no guarantee the funds rate will ever get there. After all, the funds rate “dot plot” is just an aggregation of projections of all FOMC participants.
“Like any set of forecasts, those forecasts will change over time,” Powell said, adding that is will be based on the pace of the economy.
In fact, there’s reason to think the neutral rate will be revised higher, as it was slightly from December to March. A big reason why Fed officials steadily lowered their estimate of the neutral rate from 4.25% in January 2012 was that they perceived its real component (“r*”) had fallen as slower productivity and labor force growth undermined the economy’s potential for expansion. But if Powell and others are right, tax incentives will boost investment and in turn productivity, while also increasing labor force participation. If so, we could see upward revisions in the neutral rate, which would render actual funds rate hikes relatively less restrictive.
For now, though, the outlook remains uncertain — a word Powell and his colleagues use very frequently. Dramatically increased market volatility intensifies the sense of uncertainty and in turn Fed caution. Of course, the big game changer would be a significant increase in the inflation component of the neutral rate — now assumed to be the Fed’s 2% target for the price index for personal consumption expenditures (PCE).
The Fed has had the luxury of raising rates modestly and incrementally because inflation has stayed subdued. But the PCE and other price and wage gauges have been inching higher in recent months, as have inflation expectations measures. Were there to be an inflation breakout — which a trade war with China could spark if the Fed stays overly accommodative..... — markets would have something to worry about.
The Fed may yet raise rates more sharply, but that would require more convincing evidence of faster growth and/or escalating wage-price pressures — evidence that could be available by the time the FOMC revises its projections in June.