Don’t Assume That the Fed Is Done Raising Rates

(Bloomberg Opinion) -- The U.S. Federal Reserve recently modified its assessment of the economy, saying that it will be “patient” in deciding whether to further remove stimulus. This has led financial markets to conclude that the world’s most powerful central bank won’t be raising interest rates any further in this economic cycle.

People should be careful about jumping to such conclusions. Although the Fed is likely to stay on hold for the next few months, after that it’s anybody’s guess.

I see various reasons for the Fed’s change in language and stance — none definitive, but collectively significant.

  • U.S. growth. Fed officials expect the U.S. economy to slow in 2019, in part because ongoing trade spats have added to uncertainties for businesses and consumers.
  • Unemployment. Employers have kept hiring at a healthy pace, but the unemployment rate has stopped declining. This may indicate that there’s more slack in labor market than anticipated — that is, more people are coming off the sidelines to look for work.
  • Wages. All the hiring isn’t pushing up pay like it has in the past. This suggests that either the relationship between unemployment and wages is weaker than before (in technical jargon, the Phillips curve is very flat), or that there’s still enough supply of labor to keep wages down.
  • Consumer prices. Inflation remains low, as do people’s expectations of future price increases. Weaker oil prices have pulled headline inflation (as measured by the PCE deflator) back below the Fed’s 2-percent target.
  • Growth abroad. Slower Chinese growth has affected the outlook elsewhere — most notably in Europe.

All this means that the risk of raising rates too far, and hence inadvertently causing a U.S. recession, has increased. Meanwhile, the lack of inflationary pressures means that the cost of taking a “wait and see” approach has declined. In this environment, how could the Fed explain further tightening?

How long the Fed remains patient, though, will depend on how the conditions that justified its patience evolve. Already, the case for waiting has lessened somewhat. Financial conditions have eased in 2019, as the U.S. stock market has rebounded from its December slump. Now that China is focused on stimulating growth, the global outlook is improving. And if U.S.-China talks make progress, some of the uncertainties on the trade front could be resolved.

That said, it will take more to move the Fed. In particular, the central bank needs to see evidence that U.S. growth will be strong enough to push the unemployment rate down further, and that this could cause wage and price inflation to accelerate. This is an example of “threshold effects”: Monetary policy changes in fits and starts, not smoothly and continuously. Evidence has to accumulate before it can motivate a shift in course.

Such inertia means that monetary policy is very likely on hold through the first half of 2019. Even if the economy were to do well and inflation indicators started rising, it would take some time to overcome the Fed’s current inclination to be patient. 

I expect the U.S. economy to grow faster than usual this year. This probably won’t be evident in the first quarter, because the government shutdown, trade uncertainties and underwhelming tax refunds will dampen growth. After that, the picture is likely to brighten. In particular, people are underestimating the health of the household sector, buoyed by job gains, rising incomes and stronger finances.

Fed officials will may note the improving outlook in the forecasts they issue later this month. As a result, their interest-rate projections will probably suggest that the next move, albeit delayed, will still be up. For the Fed, “patient” doesn’t likely mean “finished.”

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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