Tim Duy assesses today's decision from the FOMC to leave the target interest rate unchanged:
Cutting It Down the Middle, by Tim Duy: Today’s FOMC statement was largely in-line with expectations – worries were tilted toward higher inflation risks, but fell short of setting the stage for a rate hike in August. Will we see a rate hike this latter this year? I still tend toward expecting a rate hike sometime this fall, vacillating between September and October depending upon the intensity of Fedspeak, largely in response to energy/Dollar driven inflation concerns. Recent Fedspeak pulled me to the earlier date; this statement pushes me toward the later date.
Mark Thoma compares the two most recent statements side by side here. Some points of interest:
1. The Fed identifies some “firming in household spending,” which at first glance appears inconsistent with weak consumer confidence numbers. That firming, however, likely reflects the impact of tax rebates, and confidence remains low because households realize the spending boost is only temporary. Also, the Fed now acknowledges that higher energy prices weigh on real spending.
2. The language on the inflation forecast is tightened, but qualitatively similar, maintaining a benign outlook, although the Fed dropped its optimistic assessment of the direction of commodity prices.
3. The inclusion of the sentence “[a]lthough downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased,” shifts the balance of risks toward inflation, but not so much as to expect a rate hike in the near term.
4. There is no mention of the Dollar, although I suspect the minutes will reveal concern on that front.
The Fed is attempting to walk a fine line, with enough hawkish talk to keep the Dollar and oil in check, but not so much that they trigger a substantial rise in longer term rates such that they undermine the current fragile and tentative signs of economic stability. As the FOMC statement suggests, both growth and inflation prospects depend on the path of oil prices (See, for example, Dow Chemical’s second price increase in a month.), and I believe policymakers are genuinely concerned that easy US monetary policy is a contributing factor to this trend. Indeed, this is the only rational explanation for the heightened hawkishness at the Fed given the weak economy. Across the Curve succinctly notes:
…it is inconceivable to me that the Fed will hike rates anytime soon. The funds rate will be at the present level for a very long time.
I will offer one caveat to that view. It is a global market now and if the ECB raises rates the Fed might find it necessary to respond with a fine tuned and calibrated move of its own to protect the currency.
One interpretation for what many see as an irrational expectation of higher rates is simply that market participants are convinced that oil will continue to rise and Dollar will resume its fall in the absence of higher rates. Consequently, if the Fed is serious about these two concerns, then they must be ready to tighten policy. A signal that the Fed is just bluffing could send energy and currency markets in unsettling directions – hence the need to heighten inflation concerns and keep the possibility of a rate hike later this year alive.
For those looking for a reason to hike rates aside from immediate inflation concerns, I would point you toward the Fed’s assessment that downside risks have diminished somewhat. A portion (how much is unknown) was intended to address potential downside risks. The symmetry principle – the Fed cut rates quickly to address the credit crunch, and needs to quickly reverse the excessive portion of the easing as financial markets regain some degree of normality – would justify a rate hike this fall if those risks continue to moderate. In such a case, current policy would be fundamentally inconsistent with the Fed’s baseline forecast. This is not the same as a sustained tightening campaign, and would be better characterized as fine tuning. The Wall Street Journal’s economics blog has a nice summary of the symmetry principle here.
Summing Up: The Fed’s statement was an attempt to find middle ground; hawkish enough to signal a willingness to hike rates should the need arise, but not so hawkish that markets expect a hike this summer. I still think the odds favor a rate hike toward the end of the year, especially if energy prices and the Dollar resume their most recent trends, suggesting that US monetary policy is too accommodative. The Fed can also justify a small rate hike as simply reversing some of the risk management portion of the rate cuts as a fine tuning exercise. If global economic conditions shift to favor the Dollar and send oil prices lower, then the Fed will remain on hold until growth returns to trend.