Uncertainty breeds caution, and there is plenty of both at the Federal Reserve these days. Hence, the Fed’s “gradual” path of interest rate hikes continually gets more gradual.
A cynic might say the Fed always finds excuses for not raising rates, but from the standpoint of Fed Chair Janet Yellen and her colleagues, they are just doing what is prudent. And anyway, what’s the hurry? As New York Federal Reserve Bank President William Dudley puts it, “With uncertainties about the outlook and inflation being lower than desired, it allows us to be a little more patient.”
Economic forecasting being an imperfect science, monetary policymaking is by nature uncertain; particularly in an integrated global economy where risks are easily transmitted by financial markets. But this year, the Fed has faced heightened uncertainty. Adding to the policy conundrum has been mounting doubt about where the longer run “neutral” federal funds rate lies.
So, despite rhetoric from Fed policymakers about the need to get on with “normalization,” the Fed’s policymaking Federal Open Market Committee (FOMC) has left the federal funds rate in a 25- to 50-basis point target range since raising it for the first time in seven years last December.
When the FOMC met in January, March and April, worrisome “global economic and financial developments” and their potential contagion kept the Fed from making a second rate hike. By mid-June, much of the data showed the economy had weathered the market storms. Minutes revealed considerable sentiment for a June 15 rate hike. But an extremely weak May employment report and uncertainty about the outcome of the UK’s June 23 Brexit vote combined to keep the FOMC on hold. An ultra-cautious message emerged from Yellen’s press conference and other communications.
In their mid-year Summary of Economic Projections, the 17 FOMC participants made only modest downward revisions to their forecasts — still anticipating sufficient growth to achieve the Fed’s employment and inflation objectives. But their revised assessments of appropriate funds rate levels sent a very different signal.
Although the median funds rate projection for 2016 was left at 0.9%, implying two rate hikes this year, the officials projected a much shallower rate path than in March, not to mention December when they were looking for four hikes. They lowered their rate hike projections by 30 basis points to a median 1.6% by the end of 2017 and by 60 basis points to a median 3.0% by the end of 2018. What’s more, they further cut their estimate of the neutral funds rate from 3.3% to 3.0%. That makes a 125 basis point reduction since the FOMC started publishing its estimate in January 2012.
Reduction of the neutral rate, which may not be finished, is attributed to sluggish productivity growth and in turn weak business investment.
The surprising UK vote to leave the European Union threw markets into tumult all over again, validating the decision to stay on hold. Even though U.S. equities rallied, “Brexit” remains a likely cause for rate hike delays as highlighted in the June FOMC minutes.
Fed funds futures have reduced rate hike odds to the vanishing point, even pricing in small odds of rate cuts That is viewed skeptically at the Fed, but clearly Brexit, the resulting financial turbulence, upward pressure on the dollar and speculation about EU disintegration have made policymakers more hesitant.
The mood of uncertainty and caution was exemplified by Fed Vice Chair Stanley Fischer’s June 30 comments. “As we consider the risks of Brexit, we’ve got to put that effect on the U.S. together with what else is going on in the U.S. economy, he said.
While cautious, Fischer did not signal indefinite delay. He and others think the U.S. economy has a lot of things going for it and will be able to ride out Brexit. “The U.S. economy, since the very bad data we got in May on employment, has done pretty well,” he said.
Cleveland Fed President Loretta Mester, a FOMC voter, expressed similar views. “Ultimately, global economies will adjust to the new trading and labor relationships negotiated between the U.K. and Europe,” Mester predicted, but for now, “it is too early to judge what the magnitude of the effects on the global economy will be and, for the U.S. economy, whether there will be a material change in the medium-run outlook.”
Notwithstanding low market odds, Yellen & Co. could be ready to make another normalization move at some upcoming FOMC meeting, but they will want convincing evidence that U.S. fundamentals are strong enough to surmount global risks and generate enough growth to keep reducing unemployment and push inflation up to the Fed’s 2% target.