Looking beyond lift-off

April 15, 2015 12:00 PM

The Federal Reserve has been pointing toward a mid-2015 hike in short-term interest rates for several years, and there is every reason to believe its policymaking Federal Open Market Committee (FOMC) will at last start raising the federal funds rate in that timeframe. 

Economic and financial exigencies could cause the funds rate “lift-off” to come sooner or later, but prolonged further delay is not what most Fed officials want. 

The funds rate has been kept in a zero to 25 basis point range since December 2008, and officials are weary of staying at the zero lower bound. Holding rates at crisis levels is getting harder to justify in the face of above-trend economic growth and falling unemployment. What’s more, extending the stay at zero is seen by many officials as risking the Fed getting behind the curve, then having to tighten so sharply that it could disrupt financial markets and trigger another recession. 

The consensus is it would be better to raise rates sooner and slower than later and steeper. 
Inflation running far below the 2% target gives the FOMC pause, but Chair Janet Yellen says it need not preclude higher rates if she and her fellow policymakers become “confident” inflation will return to target “over the medium term.” 

The requisite confidence has grown. Most officials are prepared to look through soft price and wage readings and chalk them up to transitory factors, notably the oil price plunge and falling import prices due to dollar appreciation. 

San Francisco Federal Reserve Bank President John Williams—Yellen’s top advisor when she held his job—said in early March he is “quite confident that we’ll be able to reach our 2% target within the next few years. With the U.S. economy improving and unemployment falling to quite low levels, I expect wage pressures to build and price pressures to return to more normal levels over the course of the next two years,” he said, adding, “As things continue to get better, I see the strengthening domestic economy overwhelming the energy and currency valuation impacts, and inflation gradually moving back to 2%.” 

Given the quarterly schedule for Yellen press conferences and the publication of the Summary of Economic Projections, the earliest likely date for raising rates is June 17. The next such opportunity is Sept. 17. 

Yellen left the door open for a June rate hike in the Feb. 24-25 Congressional testimony. Explaining what the FOMC meant by saying it could “be patient,” she said it “considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings.” 

Later, Fed Vice Chairman Stanley Fischer said, “I don’t think that there’s an emphasis on June as opposed to September.” 

“But, if you look at the probabilities that are expressed in the views of the FOMC participants (in the SEP) or if you look at what we get from ... people who are active in the market, it seems to be those two months that get the main weight of the probability,” he added.

Williams, an FOMC voter often considered something of a dove, told me in December that mid-2015 was “a reasonable guess,” and developments since have reinforced 
his viewpoint. 

Chicago Fed President Charles Evans, another voter who has long argued for delaying rate hikes until wage gains improve, said June was only “a bit early.” 

Despite the dollar’s climb, a fear of global headwinds is giving way to talk of tailwinds.

Beyond lift-off, the bigger question is the pace of rate hikes. One thing seems certain: officials don’t want to repeat the “measured pace” of 2004-06 when the funds rate was raised 25 basis points at 17 straight meetings. Nor is the FOMC likely to adapt a monetary policy rule such as some in Congress would like to force on them. 

Fischer “know(s) of no plans to behave by following one of those deterministic paths over the next three years by raising rates at a steady rate of once every two meetings, once every three meetings or whatever. I hope that doesn’t happen. I don’t think it will happen.” 

The influential former Bank of Israel chief  says he “expect(s) that our interest rate policy will continue to be data-driven and that interest rates can be set at each meeting on the basis of what the FOMC believes will best enable us to meet our goals of maximum sustainable employment and price stability over the course of time.” 

Essentially, he advised Fed watchers that if you want to know how the Fed is going to operate in the post-lift-off normalization period, then keep your eyes and ears open. That’s what they get paid for, he cracked. 

“The FOMC will have to respond to the shocks, and as it responds, I’m sure the FOMC will seek to explain each time what it’s doing, what the goals are, and as it does that it won’t be forward guidance about what we’re going to do next week or next year,” he said, but “it will be forward guidance about how to think and about how the FOMC must behave in a stochastic environment where things change and interest rates change on an automatic basis.” 

So, says Fischer, the FOMC will follow “a flexible policy rule, and we will be able to study those actions, to study the explanations of those actions and build up a picture of how the Fed ... will behave in the future, which will provide as much guidance to the private sector and analysts of monetary policy as is possible.”

Another key issue is how the Fed will manage its $4.5 trillion balance sheet and the accompanying pile of reserves pushing down money market rates once zero rates are left behind. 

The FOMC has virtually foresworn asset sales and plans to shrink the balance sheet passively by no longer reinvesting principal payments from its holdings of agency mortgage-backed securities or rolling over maturing Treasury securities at auction. 

As the FOMC said in September 2014, it “expects to cease or commence phasing out reinvestments after it begins increasing the target range for the federal funds rate.”

But it might not be that easy. Should the Fed end reinvestment abruptly or taper the pace of reinvestment? And should it vary the pace of tapering? Should it, for example, allow fewer run-offs of Treasuries next year when massive amounts mature? 

Before he retired, Dallas Fed President Richard Fisher suggested the FOMC follow the advice of former Chinese dictator Deng Xiaoping, who said, “We will cross the river by feeling the stones.” 

Sound advice for U.S. monetary policy, no doubt, but it could get pretty rocky.

About the Author

Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of "Back From The Brink: The Greenspan Years" (Wiley).