The Federal Reserve has successfully led financial markets to price in its baseline interest rate signals for 2018. In concluding the Federal Open Market Committee meeting on Wednesday, policymakers will face the important question of how far to go in moderating expectations of rate rises beyond the baseline, and whether to counter the growing conviction among investors that the central bank is no longer in the business of providing a tight backstop for volatile stock markets.
The Fed shouldn’t go much beyond welcoming recent inflation data and reiterating its prior policy guidance. It can do so by issuing an appropriately boring statement.
On Monday, Fed policymakers received welcome news that their favourite inflation gauge, the personal consumption expenditure rate, rose in March. The overall index reached 2 per cent, up from 1.7 per cent for February, and the core measure climbed to 1.9 per cent, from 1.6 per cent. That means annual inflation is again hovering at the 2 per cent Fed target last touched briefly in February 2017. This coincides with medium-term market expectations reflected in the breakeven rates for Treasury Inflation-Protected Securities that are consistent with the central bank’s inflation goal.
If the 2 per cent level is sustained this time — and it isn’t certain to be given relatively anaemic wage growth — the Fed would have a solid case to declare “mission accomplished” on its dual mandate of maximum sustainable employment and stable prices. That realisation has pushed markets to fully price in the previously signalled path of rate hikes for 2018 as a baseline, and to tilt the balance of risks markedly in favour of a fourth rate increase.
There is also the question of stock market volatility. Unlike during many previous bouts of unsettled prices, the central bank now is more comfortable about living with larger two-way price movements, and policymakers have shown no appetite to return to the practice of making soothing statements to calm markets.
Yet, the Fed’s success in convincing markets of a more rapid return to “normal” monetary conditions also carries risks: A tightening in financial conditions that is too fast and too sharp could constitute a damaging headwind. The economy still has elements of structural slack (a labour participation rate just below 63 per cent) and faces possible operating-regime shifts (including on account of trade negotiations, eroding growth momentum in Europe and the overpromising of liquidity in certain market segments). In addition, it operates in a fluid landscape created by the impact of technology and shifting debt dynamics, along with political and geopolitical uncertainty.
In welcoming the gradual and continued dissipation of “lowflation” concerns, the Fed’s challenge after so many years of excessive reliance on unconventional measures remains to maintain a steady hand to complete a highly successful “beautiful normalisation” of monetary policy. This requires a delicate balance between inadvertently amplifying the markets’ tendency to price in an extra rate hike for 2018 and prematurely suggesting that some moderation of the tightening policy bias may be needed.
Given there policy circumstances, less is more. That is why the Fed should err on the side of a uneventful outcome to this week’s policy meeting by:
- Holding off on a rate hike until June.
- Making only minor changes to the statement when it comes to the economy’s overall prospects, while slightly upgrading the language on inflation.
- Refraining for now from signalling anything new on the so-called neutral rate.
- Continuing to maintain the same policy optionality it has signalled in the past.
- Minimising — or even better, keeping to zero — any dissenting votes among FOMC members.
- Leaving alone the previously communicated plan for balance sheet reduction.
Since the 2013 “Taper Tantrum”, the Fed has gotten much better at striking inherently delicate policy balances. The payoff has been the ability to normalise policy without derailing economic growth or causing major disruptions to financial markets.