The Case for a Patient Fed
We’ve got two good reasons for believing that interest rate hikes remain far off -- November at the very earliest. Not only did the Federal Open Market Committee’s latest missive restate the mantra about interest rates remaining at “exceptionally low levels” for an “extended period,” it also reaffirmed that economic conditions aren’t close to meeting the Fed’s self-imposed test to justify tighter monetary policy. Additionally, there’s a lot of legwork to be done before the Fed starts increasing the bellwether federal funds rate, and there are no signs of that work moving quickly.
First, none of the Fed’s three benchmarks for tightening monetary policy have been met: Lack of resource slack, inflation and inflation expectations. Nothing about any of these signals imminent constriction. The conventional proxy for “resource slack” is the unemployment rate, which the Fed reckons ought to be around 5% in a healthy, well-functioning economy. But according to the Fed’s own Jan. 27 predictions, unemployment will still be around 7% by the end of 2012.
Those same predictions foresee inflation below its long-run trend for each of the next three years. As for inflation expectations, which Fed officials continue to describe as “well anchored,” neither surveys of consumers nor of economic forecasters perceive threats ahead. Even esoteric forecasts implied by securities prices, such as the difference between conventional Treasury yields and their inflation adjusted counterparts, suggest inflation will remain modest for many years ahead.
The Fed is always free to modify its thinking, of course, but it pointedly opted not to do so, specifically citing “low rates of resource utilization, subdued inflation trends, and stable inflation expectations” as justifications for its low-rate outlook.
Second, we’re not far enough along the road that Federal Reserve Chairman Ben Bernanke mapped out for tightening monetary policy in February testimony to Congress. (Actually, the hearing itself was snowed out, but Bernanke released his planned statement, titled Federal Reserve’s Exit Strategy). In it, the Fed chairman clearly drew a line between emergency liquidity programs targeted to address the short-term financial market crisis and more conventional monetary policy aimed at controlling the money supply and interest rates. The implication: Liquidity conditions would be normalized before monetary policy begins to tighten. It is here that more work remains to be done.
For example, the Fed has historically charged a penalty rate of 1% over the federal funds target for banks borrowing at its discount window. That rate was trimmed to a mere .25% during the depths of the financial crisis and only recently, on Feb. 18, was it bumped up to .5%. Hence, this spread still needs to return to normal before the federal funds rate is hiked. There are no hints in that direction.
Bernanke also alluded in his testimony to another sequencing matter that points to the Fed draining reserves from the banking system before hiking rates. In Fedspeak, Bernanke said, “As the time for the removal of policy accommodation draws near, those operations [technically, reverse repos] could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates.” In plain English, that means the Fed is likely to extract previously loaned cash from bank vaults in exchange for less liquid securities. There’s been no concrete action along these lines as yet, either.
Interest rates won’t stay this low forever, of course. But a summertime hike just isn’t in the cards. The Fed’s preconditions haven’t been met, and the groundwork needed to precede interest rate hikes has yet to begin.