Makes You Wonder What the Fed is Thinking
by Tim Duy
The Fed is poised to raise the target range on the federal funds rate this week. More on that decision tomorrow. My interest tonight is a pair of Wall Street Journal articles that together call into question the wisdom of the Fed's expected decision. The first is on inflation, or lack thereof, by Josh Zumbrun:
Central bank officials predict inflation will approach their target in 2016. The trouble is they have made the same prediction for the past four years. If the Fed is again fooled, it may find it raised rates too soon, risking recession.
A key reason for the Federal Reserve to raise interest rates is to be ahead of the curve on inflation. But given their poor inflation forecasting record, not to mention that of other central banks:
why are they so sure that they must act now to head off inflationary pressures? One would expect waning confidence in their inflation forecasts to pull the center more toward the views of Chicago Federal Reserve President Charles Evans and Board Governors Lael Brainard and Daniel Tarullo and thus defer tighter policy until next year.
Now combine the inflation forecast uncertainty with the growing consensus among economists that the Fed faces the zero bound again in less than five years. This one's from Jon Hilsenrath:
Among 65 economists surveyed by The Wall Street Journal this month, not all of whom responded, more than half said it was somewhat or very likely the Fed’s benchmark federal-funds rate would be back near zero within the next five years. Ten said the Fed might even push rates into negative territory, as the European Central Bank and others in Europe have done—meaning financial institutions have to pay to park their money with the central banks...
Not a surprising conclusion given that Fed officials expect the terminal fed funds rate in the 3.3-3.8 percent range (central tendency) while the 2001-03 easing was 5.5 percentage points and the 1990-92 easing was 5.0 percentage points. You see of course how the math works. Supposedly this is of great concern at the Fed. Hilsenrath cites the October minutes:
Fed officials worry a great deal about the risk. The small gap between zero and where officials see rates going “might increase the frequency of episodes in which policy makers would not be able to reduce the federal-funds rate enough to promote a strong economic recovery…in the aftermath of negative shocks,” they concluded at their October policy meeting, according to minutes of the meeting.
The policy risks are asymmetric. They can always raise rates, but the room to lower is limited by the zero bound. But that understates the asymmetry. You should also include the asymmetry of risks around the inflation forecast. The Fed has repeated under over-forecasted inflation. It seems like they should also see an asymmetry in the inflation forecast that compounds the policy response asymmetry. Asymmetries squared.
Given all of these asymmetries, I would think the Fed should continue to stand pat until they understood better the inflation dynamics. The Fed thinks otherwise. Why would Federal Reserve Chair Janet Yellen allows the Fed to be pulled in such a direction? Partly to appease the Fed hawks. And then there is this from her December speech:
Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.
Yellen is wedded to the theory that the sooner the Fed begins normalizing policy, the more likely the Fed can avoid a recession-inducing sharp rise in rates. She follows up this concern with:
Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.
This is what Mark Dow calls "avalanche patrol":
What the Fed has begun to worry about is financial stability—even if not as an imminent threat. Its concerns are one part risk management, one part the ghost of crises past. FOMC members understand that financial excesses are a positive function of time. Stability sooner or later breeds instability. And the longer rates stay very low, the greater the risk they become built into the current financial architecture and baked into our extrapolations. Once you get to such a point, an eventual normalization becomes a lot riskier, in terms of both financial dislocations and economic activity.
This then becomes a story of a Fed caught between a world in which the policy necessary to meet their inflation target is inconsistent with financial stability. That is what they call caught between a rock and a hard place. And my sense is that Yellen feels the best way to slip through those cracks is early and gentle tightening.
Bottom Line: Given that the Fed likely only gets one chance to lift-off from the zero bound on a sustained basis, it is reasonable to think they would wait until they were absolutely sure inflation was coming. Even more so given the poor performance of their inflation forecasts. But the Fed thinks there is now more danger in waiting than moving. And so into the darkness we go.
