High Anxiety

Federal Reserve policymakers meet this week to set monetary policy. The key concern is the timing of policy normalization. Officials may be anxious to begin lifting short-term interest rates, but they need to be very careful about managing market expectations. The risks of tightening too soon or too late are not symmetric and with the financial markets in turmoil, the Fed will not want to add to the level of anxiety.

The liftoff for short-term interest rates will be driven largely by the Fed’s view of the labor market. There are many labor market gauges. The Labor Market Conditions Index, a composite of 24 indicators, provides a good summary (according to Fed Chair Yellen). While there is some choppiness from month to month, the underlying trend suggests that labor market slack is being gradually taken up and momentum in the job market has been strong in recent month. Still, a lot of slack remains and it will likely be two years or more before we get to what might be considered “normal” labor market conditions.

Working back from where the job market is expected to be in two years and assuming a slow pace of rate hikes (25 bps per FOMC meeting), then it would seem appropriate to begin tightening around the middle of next year. The Fed would not be hitting the brakes. Rather, it would simply be gradually taking the foot off the gas pedal.

What are the risks of tightening too soon or two late? If the Fed tightens too soon and the economy slows, it will have a limited ability to correct course, as short-term interest rates are already close to zero and officials will be very reluctant to pursue another round of quantitative easing. If the Fed tightens too late, the economy would begin to overheat and inflation would begin to rise. However, the Fed has the scope to raise short-term interest rates more rapidly – that is, it has a greater ability to correct its course.

In 2011, inflation picked up. Some observers feared that the Fed was behind the curve and wanted it to unwind accommodation. Instead, the Fed cited “temporary factors” and focused on core inflation, and continued to act aggressively. The current low inflation trend is also seen, by many Fed officials, as transitory. Low inflation, by itself, is not enough to postpone a Fed tightening. However, the conditions driving low inflation matter. For example, some of the drop in energy prices reflects increased supply. The Fed need not worry about that. However, some of the drop reflects weaker demand, which is a concern. Yet, the drop in demand is coming from the rest of the world. It’s not due to weakness in the domestic economy.

What about the stronger dollar? Would the Fed postpone tightening to reduce the upward pressure on the greenback? Remember, the exchange rate of the dollar is not the Fed’s responsibility. The dollar is under the Treasury’s jurisdiction (although the Fed may intervene in the currency markets on behalf of the Treasury). Yet, the Fed needs to consider the impact of a stronger dollar. A stronger dollar, as we’ve seen, puts downward pressure on commodity prices, but the impact at the consumer level is usually small. It takes a major move in prices of raw materials to move consumer prices even a little. The exception is oil, where the decline has a bigger impact and shows up relatively quickly. Still, oil prices are not expected to fall forever. They should stabilize at some point.

Following NY Fed President Dudley’s recent speech, we now know that the Fed will also consider the financial market reactions (or overreactions) to its policy moves, and possibly react to the market’s reaction. The recent stock market turmoil and drop in long-term interest rates makes the Fed’s decision to remove the “considerable time” phrase a lot more complex. Janet Yellen can attempt to calm the financial markets in her press conference, but will the markets listen?

© Raymond James

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