The policy tightening kicked off by the Fed this week promises to be among the longest and slowest of modern times, a crawl forward that may last as long as former fed chair Paul Volcker’s legendary battle against inflation in the 1980s.
Janet Yellen faces a different challenge – inflation is low, yet the Federal Reserve aims to bring borrowing costs to more “normal” levels after seven years near zero. However, the forecasts released by Fed officials on Wednesday imply that she will need as much patience as the cigar-chomping Volcker did three decades ago.
While Volcker and predecessor Arthur Burns steadily ratcheted rates higher over four years to cool the economy, Yellen will be nudging rates upwards while still keeping policy “accommodative” – loose enough to encourage borrowing and spending – until some time in 2019, according to the latest forecasts from Fed officials.
Yellen’s confidence in the strength of the recovery, voiced at a Wednesday news conference, still stands in contrast to a treacherous global environment of falling prices and weak growth. One thing the Fed is keen to avoid is the sort of forced policy retreat experienced in recent years by the European Central Bank and others that raised rates only to cut them again later.
“The key question is whether the U.S. economy is finally robust enough not only to sustain its own recovery but also to lift world trade and global growth,” HSBC global chief economist Janet Henry wrote in an analysis of the Fed meeting.
It could take years to find that out as the Fed treads a path to higher rates, with markets expecting an even slower pace of rate hikes than the Fed itself foresees. (Graphic: tmsnrt.rs/1QPRpuD)
“On a historical basis they are being anything but aggressive,” said Erik Weisman, chief economist with MFS. “It may be one of those moments where market participants need to see inflation flowing through, need to see growth,” before believing the Fed will keep moving.
Trading in Eurodollar contracts on Thursday indicated investors expect the Federal Funds rate to still be below 1 percent at the end of 2016, roughly half a percentage point below the median forecast of Fed policymakers.
“From now on, the base case is for the Fed to go slow,” in particular as policymakers digest evidence that the neutral Federal Funds rate may have shifted lower, said Cornerstone Macro economist Roberto Perli.
Though difficult to pinpoint, the neutral Federal Funds rate is among the Fed’s key metrics. It is the level considered consistent with steady growth, stable price increases, and full employment. Lowered estimates of the neutral rate imply lowered economic potential, and also imply that the Fed has less room to hike rates before it starts restricting growth.
Some economists now think the neutral rate may not be far above zero.
It is a border Yellen and her colleagues will want to approach with caution, and the promise to do so was considered key in winning over skeptics and making the “liftoff” decision unanimous.
Though all 10 voters on the Fed’s policy setting committee supported the initial hike, two registered a quiet protest of sorts by indicating in their forecasts that they felt the “appropriate” rate for the end of 2015 remained near zero. Those forecasts are anonymous, but in recent weeks Fed governor Daniel Tarullo and Chicago Federal Reserve Bank President Charles Evans both said the central bank should hold off until some time in 2016.
Others remain concerned that weak growth globally is a sign something fundamental has changed about inflation, productivity and other parts of the economy – and are likely to fight any second hike until they are convinced otherwise.
Even those most concerned about inflation have endorsed the idea of moving gradually. Policymakers’ latest projections offer gives some clues of what that means. The median forecast for the end of 2016 is 1.4 percent, or a roughly one percentage point increase over the next 12 months, and all but three of the Fed’s 17 canvassed policymakers see the rate at that point or lower next year. The median for the end of 2017 is another percentage point higher, at 2.4 percent.
The estimated neutral rate of 3.5 percent would be reached sometime in 2019. While that would end the era of accommodation, the tightening cycle – if it gets that far – could continue much longer depending on the growth and inflation outlook at that point. Rates in the last three Fed tightening cycles have peaked at 6.0 percent, 6.25 and 5.25 percent.
The promise of gradualism and well-telegraphed “liftoff” helped markets digest the Fed’s first-in-a-decade rate move with little disruption. The euro was down about 1 percent against the dollar on Thursday; global equities rose overnight while U.S. stocks gave back some of the gains that came in the immediate aftermath of the Fed meeting.
(Reporting by Howard Schneider; Editing by Tomasz Janowski)