A pre-emptive versus a data-driven Federal Reserve

Immediately following the Federal Open Market Committee’s (FOMC) decision on March 15 to raise the Fed funds rate to 0.75 percent to 1 percent, bond and equity markets rose in spectacular fashion. Currency markets quickly joined in the fanfare, sending the U.S. dollar sharply lower. In what is considered a “Goldilocks” environment for risk assets, the simple message from Chairwoman Janet Yellen is “the economy is doing very well.”

Since the credit crisis, the FOMC has worked tirelessly to convince markets that all policy decisions will be highly data dependent. Delivering a 25 basis point move in December, coupled with another 25 basis point hike 12 weeks later, the Fed is sending a clear message that the U.S. economy is on a solid path to growth.

The March move marks the third increase in rates since adoption of the zero interest rate policy, suggesting rates are still quite truncated near the lower bound of the interest rate spectrum. With Core PCE (Personal and Consumption Expenditure) hovering around 1.7 percent and the diffusion index of major inflation components remaining very much in negative territory, inflation, while inching up a bit, is not at levels to be concerned. Analogous to these factors, there is little evidence of significant wage pressures on the horizon.

This then begs the question, if prospects for the U.S. economy appear to be as well anchored as the Fed advocates, what accounted for the dovish sentiments in the FOMC reports?

The recent tightening actions and optimism from the chairwoman seem to run counter to those sentiments. For the two previous hikes, the FOMC unanimously voted to support the 25 basis point moves. The most recent hike, however, saw one voting member dissenting in favor of maintaining the existing target range. In addition, the forecast for the natural rate of unemployment was trimmed by one-10th of a percentage point, suggesting that slack remains even as employment improves and prime-age working Americans re-enter the labor force. With further revision still on the table, the labor market may have much more room to run before wage pressures (the greatest contributor to inflation) becomes a real concern.

Janet Yellen, chair of the U.S. Federal Reserve, during a House Financial Services Committee hearing in Washington on Feb. 15, 2017. MUST CREDIT: Bloomberg photo by Aaron P. Bernstein.

Perhaps the strongest dovish sentiment in the reports was the change in the committee’s statement surrounding its inflation target. While the Fed lifted its Core PCE forecast by one-10th of a percent to 1.9 percent for 2017, the change in rhetoric from monitoring “expected progress toward its inflation goal” to “inflation developments relative to its symmetric inflation goal” was significant. Unlike the European Central Bank, where the mandate calls for a 2 percent inflation ceiling, the Federal Reserve’s dual mandate of maximum employment and price stability targets a 2 percent medium-term inflation rate.

As Minneapolis Fed President Neel Kashkari recently argued, having a target rate is very different from having an inflation ceiling. With an inflation ceiling, policy response is warranted to keep inflation below that target level. With a symmetric inflation goal, however, many have interpreted this to mean the committee may now allow inflation to drift above the 2 percent target rate with equal concern, for example, if inflation undershoots at 1.7 percent or overshoots at 2.3 percent. Consequently, with inflation firmly anchored at 1.7 percent for the past seven months, possible trimming of the natural rate of employment and little or no wage pressures in the near term, what warranted the recent increase in rates?

Yes, the hawks point to steady progress in the economy and cite the robustness and resilience of financial markets. Economic forecasts have also been optimistic, with Gross Domestic Product revised upward to 2.1 percent for 2018, inflation expectations close to 12-month highs and the median projections for the Fed funds rate climbing to 3 percent for 2019. But the question still remains, do higher projections warrant an increase in rates? Or, should the Fed commit to policy actions based on evidence inherent in the economic data?

Rightly or wrongly, the Fed is operating in uncharted territory following its quantitative easing program and, admittedly, it is difficult to ascertain how markets will react when balance sheet normalization begins. It is also true that the FOMC has more policy tools at its disposal to fight higher inflation versus inflation coming up short, and is therefore more prepared in the former scenario than the latter. Given this well-known bias, however, it may be prudent to just be patient and allow inflation to climb beyond its 2 percent target versus pre-empting the data and risk falling short.

Statistics and Data Sources: Bloomberg LP., BCA Research, Federal Reserve
The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.