Today the Federal Reserve raised the base USFed Funds interest rate a quarter percentage point to the range between 0.75% and 1.00%. There was only one dissent from Minneapolis Fed President Neel Kashkari. And because this move was anticipated by everyone, the real question now goes to what comes next.
When we think of how the Fed will move going forward, we have to remember that the Fed has only two formal mandates— price stability and full employment. There is nothing about economic growth, exchange rate volatility, yield curve steepness or anything else that is directing Fed policy. The Fed does have an underlying role in preserving financial stability. But short of a crisis, that role is very much a secondary one two its dual mandate.
On price stability, the question is whether Fed officials believe they need to act pre-emptively to ward off inflation. In the past, that’s how the Fed has acted. And this pre-emptive tightening has invariably led to an inverted yield curve at some point in the business cycle, a sign of impending recession.
The fact that the Fed has raised rates twice before we have even hit the Fed’s 2% inflation mandate suggests that this pre-emptive thinking may still dominate Fed thinking. At the same time, Chair Yellen was at pains to stress during the Fed’s post-meeting press conference that she thinks the Fed Funds rate is still below a so-called neutral rate and that the Fed is, therefore, still adding policy accommodation. So the jury is still out on whether the Fed is tightening pre-emptively.
We do know, however, that some market participants now believe the Fed is behind the curve – something that will mean much more future tightening than anticipated. Here is a chart from Goldman Sachs’ Jan Hatzius comparing what the Fed Funds rate should be under a Taylor Rule approach and where it has been.
Notice that this shows the Fed being something like 2 or 3% too easy, meaning that — according to this rule —the Fed Funds rate should be something like 2.75 to 3.75% instead of 0.75%.
Others are arguing that the Fed is raising rates too quickly. They argue that downside risk will remain until real wage growth rises more consistently, underpinning growth. To wit, if one looks at the Atlanta Fed’s GDPNow calculation for the present quarter, the numbers released today show GDP growing less than 1%, a marked and worrying deceleration.
I mentioned the credit growth deceleration on Monday. That is another worry here as well.
On the jobs front, the difference is between those who are concentrating on broader measures of labor market slack like the U-6 level of unemployment or labor market participation percentages. Both of these numbers show slack in the labor market relative to the best numbers of the 1990s business cycle.
But the Fed seems much more concentrated on the headline level of unemployment, which now stands at 4.7%. Again, while this number is higher than the late 1990s levels, it is at or below the Fed’s stated thresholds for full employment.
My take: The Fed has wanted to raise rates for some time. The economic data just hadn’t been good enough for them to do so. Now we have finally hit a point where the employment and inflation numbers are close enough for them to press forward with policy normalization. While data like the Atlanta Fed GDPNow deceleration is worrying, I believe the Fed’s actions will be largely dictated now by where unemployment and inflation go relative to their stated objectives.
If unemployment drops less than expected or inflation does not move toward 2% as expected, the Fed will take longer to normalize policy. But if unemployment goes down quickly or inflation overshoots, the Fed will tighten more aggressively irrespective of what numbers like GDPNow predict. The steepness of the yield curve will be the best gauge on whether these decisions are a risk to economic growth.