Wednesday's rate hike a turning point for US economy
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Monetary policy has been super-easy for many years, and the normalization process for interest rates has been dragging. The Federal Reserve raised rates only once in 2015 and in 2016 (in both cases, waiting until December), setting the tone for the most “gradual” rate hike cycle in history.  

Yesterday marked the point when the Federal Open Markets Committee (FOMC) — the body within the Fed that implements rate changes — decided to shift gears and begin moving monetary policy back toward normal.  

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The quarter-point rate increase announced yesterday marked the Fed’s second move in three months. It also indicated that, after failing to follow through in 2015 and 2016 on projections of multiple rate hikes each year, Chair Janet Yellen and company mean business this time.

 

Unfortunately, after having led the financial markets to the brink of rate hikes numerous times in recent years before failing to follow through, the Fed has taught market participants to be understandably skeptical.

Even as the FOMC announced a rate increase yesterday that markets had only come to expect within the last two weeks following an intense campaign of “jawboning” by Fed officials, investors reacted with relief to the FOMC statement and rate projections.

Stock prices surged and interest rates fell. This reaction appeared to stem from the fact that the FOMC’s median projections for the policy rate did not rise for the end of 2017 or 2018. The financial markets are vulnerable to missing the forest for the trees.

The broad reality is that the economy is close to full employment — the unemployment rate sits well below 5 percent — and inflation is finally starting to rise, already nearing the Fed’s 2 percent target. Monetary policy is still very easy — the funds rate is running well below the prevailing inflation rate, implying a significantly negative “real” interest rate, the hallmark of an easy stance by the Fed.  

On top of that, the Fed’s balance sheet still stands at $4.5 trillion, providing heaps of excess liquidity that are sloshing around in the financial system and creating lofty valuations for a variety of financial assets.  

As Chair Yellen has noted many times, the Fed does not want to wait until the economy and/or financial markets have overheated to normalize monetary policy, because then it has to tighten too far or too fast, a recipe that has too often ended with a recession.  

The current Fed has tried to have its cake and eat it too, offering to be “patient” — keeping rates low until basically every downside risk has dissolved — but also promising to raise rates in a “gradual” way, so as not to be disruptive.  

The March rate hike should be thought of as a pivot point in the current interest rate cycle, as it marks the first time that the Fed has tightened more than once in a short window of time. It also provides definitive evidence for the first time that the Fed actually intends to follow through on its own forecasts.

The Fed’s latest round of interest rate projections call for two more quarter-point rate moves this year, followed by three hikes in 2018 and three-and-a-half in 2019. This would take the policy rate to 3 percent by the end of that year, in line with where the Fed thinks it should average in the long run.  

That trajectory would be a far cry from the annual 0.25-point-per-year pace implemented in 2015 and 2016. In addition, while financial markets are pricing in more rate hikes now than they were a few months ago, the Fed’s forecasts are still substantially more aggressive than the markets’.

Moreover, the Fed’s interest rate projections are underpinned by economic forecasts that represent a best-case scenario, with the unemployment rate settling at 4.5 percent and inflation magically plateauing at exactly 2 percent.

In reality, the economy is likely to overshoot on both metrics, with red-hot labor markets and strong demand eventually leading to building inflation pressure. In that case, the Fed will have to either speed up the pace of its rate increases or push rates to a much higher stopping point, exactly the outcomes that the Fed had hoped to avoid.

There will be plenty of time for financial markets to mull over the implications of yesterday’s decision. The next time the Fed is likely to consider a rate increase is three months away, in mid-June. In the meantime, investors should be careful to watch for signs that the economy is moving into overheated territory.

 

Stephen Stanley is the chief economist for Amherst Pierpont Securities, a broker dealer providing institutional and middle-market clients with access to fixed-income products.


The views expressed by contributors are their own and not the views of The Hill.