Good retail sales numbers made a rate hike by the US Federal Reserve almost certain. The rise that finally did take place on Wednesday was well signalled to markets that cheered the rise, with Dow, Nasdaq and the S&P all climbing on the day by more than 1%. Thursday, however, the market was down.
The so-called ”dot plots”, which show the interest rate forecasts of all 17 attendees at the Federal Open Market Committee meeting, suggest that there will be four more rate rises in 2016. This seems unlikely and the market doesn’t believe that either and expects only two.
It seems to me there is a 50/50 probability that this hike will have to be reversed and the worry is that this might mean rates going negative. This is what happened with the European Central Bank, which raised rates twice in 2011, and now has negative rates.
In the period since the onset of the great recession every central bank that raised rates, including those in Sweden, Denmark, Canada, Switzerland, New Zealand and Israel were forced to reverse course when their economies slowed and it became clear that they had raised too soon.
One of the most interesting pieces of information was that the decision was unanimous. Lael Brainard, Charles Evans and Daniel Tarullo had all signalled they were not supportive of a rise, but in the end voted for it. It is clear they didn’t want to weaken Janet Yellen’s position for the battle that will come in 2016. In the end, this was about the chair asserting her dominance over the committee. It is now Yellen’s Fed.
My main concern is that it is especially hard to understand the rate rise,given that the Fed has a dual mandate – to maintain stable prices and to maximise employment. There is no inflation: and inflation expectations seem to be de-anchored and the economy is a long way from full employment.
The Fed’s inflation target of 2% uses the price index for personal consumption expenditures (PCE), which has been around 0.2% for the past year, due only partly to a steep decline in crude oil prices. Even the rate of core PCE inflation, excluding food and energy prices, has been trending downward since 2011 and currently stands at 1.3%. The Fed has been overly optimistic, regularly forecasting that core inflation would soon turn upward and converge back to its target. But it hasn’t. There is little or no prospect it will do that now: the rate rise will lower core inflation.
The continuing appreciation of the US dollar and falling global commodity prices make it highly plausible that the shortfall in core inflation will get worse in coming quarters. It also appears that inflation expectations, both of professional forecasters and households, have become de-anchored below the Fed’s target.
According to the results of quarterly surveys conducted by the Federal Reserve Bank of Philadelphia in 2013 and 2014, the median forecast for the five-year average PCE inflation rate was very close to the Fed’s target, whereas over the past several quarters that median has declined notably and currently stands at 1.7%. Plus, households’ longer-term inflation expectations have also moved downward significantly over the past year. This is worrying.
Unfortunately, inflation expectations may continue to decline over coming quarters, especially if actual inflation remains subdued or drops even further. My Dartmouth colleague Andrew Levin, who was an adviser toJanet Yellen and Ben Bernanke, has suggested, and I agree, at this juncture it is imperative for the Fed to reframe its policy strategy and shore up the credibility of its inflation target. One way of doing that would be to de-emphasise the role of inflation forecasts, which have been persistently wrong over the past few years and instead to link the timing and pace of policy normalisation to actual outcomes for inflation and employment. As Larry Summers has argued rates shouldn’t rise until we see the “whites of the eyes” of inflation (£).
The US unemployment rate rose to a high of 10% and has now fallen back to 5%. If the US labour market was close to full-employment there should have been a fairly rapid rise in wage growth, which hasn’t happened. The fall in the unemployment rate has been accompanied by a big rise in the proportion that have left the labour force.
There has also been a rise in underemployment – measured by the number of workers who are part time for economic reasons – and this remains well above pre-recession levels. Underemployment and those leaving the workforce: these measures gave not fallen at anything close to the rate that unemployment has. Along with unemployment they continue to keep wage growth down.
The concern is that this rate rise may have to be reversed if the US economy slows. The next recession is overdue. The decision by the Fed to raise rates is what I have called “fingers-crossed and hoping” economics. Let’s hope it works out for them.
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