A Compelling Argument for the Fed to Stay the Course of Rate Normalization

September 18, 2017

This week’s Federal Open Market meeting is not expected to raise the 1.00-1.25% federal funds target but is nonetheless anticipated as an event that may shed many clues regarding future policy. The disconnection between a tightening labor market yet continuing sub-target inflation has kindled speculation that there may not be any further interest rate increases during 2017. There already have been two 25-basis point hikes, which in addition to a duo of similarly sized increases in the final meetings of 2015 and 2016, brings the cumulative increase of the federal funds rate target to one full percentage point.

A lesson of the last 15 years or so is that the inertia that made inflation reduction so difficult in the 1980s and early 1990s subsequently whipped around. It’s now equally, if not, more difficult to accelerate inflation to a mere 2.0%. After four straight years of below-target U.S. inflation, it may be very tempting for officials to pause rate normalization until they are sure beyond any reasonable doubt that inflation will climb to its target. Given a poor track record of anticipating future inflation, confidence in the baseline forecast of rising inflation is likely not as strong as it was a year ago. The common theme behind the difficulty of cutting inflation sustainably in the last quarter of the 20th century and raising inflation this century is the heavy influence that inflation expectations has on actual inflation.

The case for a third rate increase no later than December still seems strong. For one thing, one really doesn’t know until one has passed and seen inflation move up exactly when the tipping point on price expectations is reached. The Fed’s track record of predicting business cycles has not been as accurate as one would hope, and the mistakes tend be ones of changing gears too late rather than prematurely. While the central bank acted heroically and forcefully in 2009, the Fed did not anticipate the downturn’s fury until then.

When the subprime debt crisis first surfaced in August 2007, the Fed met and held the funds rate steady at 5.25%, a cyclical high. The first cut was made in September 2007 and the target at year’s end, coinciding with the onset of recession, was at 4.25%. 225 basis points of rate reduction to a 2.0% target were implemented in the first four months of 2008, but the rate was kept at that level through three ensuing FOMC meetings and the collapse of Lehman Brothers and not cut again October 8th by which point the recession had festered for three quarters and was rapidly evolving into a monster downturn.

The most compelling reason for another rate hike by yearend is not that Fed officials may be forecasting growth and/or inflation inaccurately but rather that there is an urgency to be in position to affect the economy when the next U.S. recession begins. The federal funds target is now 1.0-1.25%. At the beginning of previous monetary policy rate downturns, the target was at 5.25% in September 2007, 6.5% in January 2001, and 9.75% in May 1989. The U.S. business cycle upswing is now 100 months old, and the average duration of nine previous expansions since the Second World War is 57 months. In a half year, this recession will become the second longest postwar expansion.

The Fed is also handicapped by the constraint of not wishing to raise its policy rate in increments greater than 25 basis points. The last hike to exceed that norm was done in May of 2000, and that was a move from 6.0% to 6.5%. An increase of 50 basis points from the current level, or anything below 2.5% for that matter, would probably have a much greater dampening effect.

The risk of tightening again this year for the sake of fattening up the interest rate war chest for the next rainy day is that the medicine in fact expedites the next downturn. However, the trade-weighted dollar has declined nearly 11% since the final week of 2016, and that should be more than enough to neutralize the tightening impact on U.S. monetary conditions of the two 25-basis point hikes already implemented this year. With the nominal federal funds rate being still incredibly low, the downside risks of raising it again this year are risks worth taking.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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