Federal Reserve State Of Play – By Steve Beckner

As 2016 got underway in earnest, Fed policymakers continued to echo the mantra of gradual interest rate "normalization" enunciated by the Federal Open Market Committee on Dec. 16. But some nascent doubts have begun to creep in about the wisdom of proceeding with a second rate hike in the near future amid global financial market turmoil, worries about the Chinese economy, Middle East tensions, collapsing oil prices and signs of slowing in an already fairly sluggish U.S. economy.

It’s begun to look like the next rate hike may have to wait for awhile. It was never very likely the FOMC would raise the funds rate again at its Jan. 26-27 meeting. Nor was it certain it would do so March 15-16 meeting, the first at which Chair Janet Yellen is scheduled to hold a press conference and FOMC participants will publish their first Summary of Economic Projections, including new funds rate assessments. Those dates may now be even less likely occasions for the next move.

A big reason is that since mid-December, the Fed has verged on facing the kind of world it confronted last September 17, when it delayed liftoff because, as it said, "recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term."

Atlanta Federal Reserve Bank President Dennis Lockhart was explicit about the importance of such "global economic and financial developments" in response to a question from MNI Monday.

Lockhart had downplayed external risks to the U.S. economy in an Atlanta Rotary Club speech and said he "expect(s) further rate increases will be justified by economic performance in 2016." He forecast sufficient economic growth to make further labor market improvements and push inflation toward 2%.

But when asked how long global financial turmoil would have to persist before he would become more concerned that it might hurt the U.S. economic and monetary policy outlook, he replied that MNI was "right" to reference the events of last August, to which the September statement referred because "last week was reminiscent of August."

"Some of that turmoil (in August 2015) lasted for several weeks," he recalled. "By the October meeting I had not yet been satisfied that I had seen enough clear indication that we were beyond the volatility that had developed in August" to support a rate hike. Not until the December FOMC meeting was Lockhart satisfied that global market turmoil was not going to significantly damage the U.S. economy and "reasonably confident" inflation was headed toward 2%.

Fast forward to the latest turbulence: "If the volatility continues for several weeks I may have to revise my view that I don’t see a connection" between global markets and the economy," Lockhart said. "It’s a matter of how long it lasts. "A matter of several weeks can begin to have an influence on the real economy."

Lockhart virtually ruled out a January 27 rate hike, saying his "bias would be in all likelihood to look through the January meeting to a later meeting" because "I don’t personally see that I know a great deal more than I knew in December." As for March, he said, "We will have some new (inflation) data but not a great deal more" then.

Boston Fed President Eric Rosengren, a 2016 voter who supported liftoff, put heavy emphasis on global risks. He said he "hope(s) the economy continues to improve, so that further normalization is appropriate," but cautioned, "policymakers should take seriously the potential downside risks to their economic forecasts and manage those risks as we think about the appropriate path for monetary policy….It is important … to carefully manage risks to the economy, including those emanating from abroad."

Rosengren said the median FOMC projection of four rate hikes this year is "a reasonable estimate of the likely path of the federal funds rate," but said "such a forecast does have downside risks. These downside risks reflect continued headwinds from weakness within countries that represent many of our major trading partners, and only limited data to support the projected path of inflation to target seen in the SEP, at least to date."

"Further tightening will require data continuing to be strong enough that growth will be at or above potential, so that Federal Reserve policymakers can be confident that inflation will reach our 2 percent target," Rosengren added.

Meanwhile, new Dallas Fed President Rob Kaplan said he "would not be surprised to see more bouts of volatility in the financial markets" and said "the challenge for policymakers is to appropriately consider these movements, without over-reading or misinterpreting them, in assessing underlying economic conditions."

For now, Kaplan (like Lockhart a non-voter this year) believes that "continuing along the path of monetary policy normalization is important. There are various costs to maintaining excessive accommodation for too long — particularly in terms of potential distortions in investment, inventory and hiring decisions, which may need to be (painfully) unwound when policy normalizes…..(I)f we delay further normalization until we actually see evidence of excessive accommodation, there is a risk that we will have waited too long."

Kaplan doubted whether "there’ll be enough info between now and January" to move again later this month but didn’t rule out a March hike: "Between now and March, yes, I think there will be. We’re just going to have to assess data as it comes out."

As for the effect of financial turmoil, Kaplan said, "We’ll have to see the implications of what we’ve witnessed over the last six business days. We may not turn out the way August-September did, but we went through this in August and September. We paused, we watched, we let events unfold, which was the right way to handle it, and we saw ultimately that the underlying economic conditions remained intact and solid. But it takes time to determine that."

Chicago Fed President Charles Evans, who voted for liftoff in December, reiterated his cautious approach to further rate hikes, saying, "policy should plan to follow an even shallower path for the federal funds rate than currently envisioned by the median FOMC participant."

 

Alan "Ginger" Taylor Founding Partner T +44 (0)20 7422 2977 M +44 (0)7825 625 925 E alan.taylor@archr.com 49 Carnaby Street, London, W1F 9PY United Kingdom ARCHR.COM

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