There is a growing set of legitimate domestic and external questions that influence what the Fed will end up doing
US Fed route for rate rises may not be so clear cut
Remarks by Fed officials late last week at the symposium in Jackson Hole, Wyoming, confirmed the consensus market expectation that the US central bank will hike interest rates two more times this year, delivering the biggest annual tightening in more than a decade.
The increases would be carried out even as the Fed is reducing the size of its $4 trillion balance sheets. Yet, judging from the most important signal, the headline speech by chairman Jerome Powell, this path may be far from set in stone.
There are two good reasons why market participants have paid so much attention to the annual gathering of domestic and foreign central bankers. First, some Fed chairs have used the venue to signal major policy initiatives (as Ben Bernanke did in 2010, with the second round of quantitative easing). Second, the forum allows the media unusually good access to central bankers.
Last week, the majority of Fed officials interviewed reinforced the notion that the Fed will raise interest rates in September and December. This message was bolstered by Mr Powell, who indicated that “further gradual increases in the target range for the federal funds rate will likely be appropriate”.
This strengthening of the prior policy signal took place against the backdrop of what Mr Powell briefly alluded to as “risk factors abroad”. But the Fed chief chose to emphasise the strongly expanding US economy. “With solid household and business confidence, healthy levels of job creation, rising incomes, and fiscal stimulus arriving, there is good reason to expect that this strong performance will continue," he said.
These markers point to unemployment and inflation at levels consistent with the Fed's targets and sustainable economic growth, notwithstanding some recent weakness in the housing and auto sectors. Yet it is only a matter of time before these vulnerabilities are perceived to be spreading by those who incorrectly see the continuously flattening yield curve (the differential between two-year and 10-year bonds reached 19 basis points last week) as an indication that a major economic slowdown is approaching.
Still, the external uncertainty is multifaceted, with an added downside risk of a self-feeding vicious cycle.
Although earlier this year many embraced the prospect of a synchronised global pick up, growth paths have diverged as uncertainty has gained in Europe and China. The currency crisis in Turkey is far from over, especially because the government continues to rule out the use of two important policy tools (interest rates and intervention by the International Monetary Fund). Meanwhile, the renewed decline of emerging-market currencies last week imperils countries with considerable foreign-exchange mismatches and large immediate funding needs.
Then there are the many US domestic economic puzzles that Mr Powell covered in his speech. The structural uncertainties that underpin the need for what he called a “risk management strategy” are linked to a relatively long list of issues, including wage and productivity behaviour, technological innovations, the international trade regime and the impact of changing demographics and fiscal impulses.
That means “the topic of managing uncertainty in policy making remains particularly salient,” Mr Powell said. And this is reflected in unusual fluidity in the metrics that Mr Powell elegantly called “very much akin to celestial stars”: the combination of r-star (the natural rate of interest), u-star (of unemployment) and π-star (the inflation target). As such, the Fed’s task of avoiding “the two errors” of under and over-tightening is “challenging today because the economy has been changing in ways that are difficult to detect and measure in real time”.
Another factor is the uncertainty Mr Powell has mentioned in the past, but dealt with only in passing this time under the rubric of “destabilising excesses.” These include excessive risk taking and over-extension in financial markets that, if left unaddressed, present risks to the economic outlook. In other words, the possibility that the interest rate/balance sheet policy stance that delivers on the dual mandate of employment and inflation may not necessarily be consistent with financial stability. And just like the “stars” this uncertainty is also two-sided.
All of this indicates that, beyond September, the prospects for monetary policy could become increasingly uncertain. No matter how confident several of the regional bank presidents appeared at Jackson Hole, there is a growing set of legitimate domestic and external questions that influence what the Fed will end up doing in December, let alone next year.
I wouldn’t be hugely surprised if a rate increase in September wasn't followed by one in December. In another scenario, the Fed would carry out the September and December increases but take a longer pause in March.