Fed Sees Further Gradual Rate Hikes With Economy Close to Goals

(Bloomberg) -- The Federal Reserve Board underscored its commitment to a gradual pace of interest-rate hikes in its semi-annual monetary policy report to Congress, which also addressed topics ranging from monetary policy rules to labor force participation.

The Federal Open Market Committee “expects that further gradual increases in the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, strong labor market conditions, and inflation near the committee’s symmetric 2 percent objective over the medium term,” the Fed said in its Monetary Policy Report to Congress released in Washington on Friday.

The Fed has raised rates twice so far in 2018 and has penciled in another two hikes this year as it balances the risks of raising rates too slowly -- resulting in too high inflation and asset bubbles -- or going too quickly and throwing the economy into a recession.

Chairman Jerome Powell, who’ll present the report when he appears before Congress next week, said the U.S. economy was in a “really good place” in an interview with American Public Media’s “Marketplace” program on Thursday, while cautioning that higher trade tariffs could pose a risk to growth.

Oil Prices

The Fed Board report noted the jump in oil prices over the past year, but added that there should be “much less” of a net overall drag on the economy as investment and production in the U.S. energy sector rise. The report said the rise in oil prices since last year translates into a roughly $300 increase in annual expenditures on gasoline for the average household, from about $2,100 to $2,400.

Inflation has crept up slowly, with the Fed’s preferred measure, minus food and energy prices, touching the Fed’s 2 percent target in the 12 months through May.

The Fed characterized overall risks to financial stability as low, saying the nation’s biggest banks were “strongly capitalized and would be able to lend to households and businesses even during a severe global recession.”

For businesses and households together, the ratio of debt to the size of the economy was “about in line with estimates of its trend, although pockets of stress are evident,” the report said. In particular, the Fed noted that delinquency rates for some forms of consumer credit had risen, “suggesting rising strains among riskier borrowers even with unemployment very low.”

The report said vulnerabilities associated with leverage in the financial sector appear low, however, “some measures of hedge fund leverage have increased.”

Outside U.S.

The report also said risks to stability from outside the U.S. were “moderate overall.”

“Globally, potential downside risks to international financial markets and financial stability include political uncertainty, an intensification of trade tensions, and challenges posed by rising interest rates,” the report stated.

U.S. unemployment dipped to 3.8 percent in May, matching its lowest level since 1969, before ticking up to 4 percent in June. The Fed report included a short study on labor force participation rate, or LFPR, saying that the rate for prime age workers between 25 and 54 years old has moved up “notably and consistently” since 2013.

“The recent increases in the prime-age LFPR, in the context of the longer-run trend decline, raise the question of how much additional scope there is for further increases” in prime-age participation, the report said.

The report again highlighted monetary policy rules, an issue raised by House Republicans who have pressured the Fed to pursue less discretionary policy. The report discussed a range of rules while noting the U.S. economy is “complex” and many rules don’t capture “elements” relevant to monetary policy.

Bank Reserves

The report also devoted a special section to the interest the Fed pays on bank reserves, a tool the central bank has used since the financial crisis to control short-term interest rates.

That tool, however, has proved less effective in recent months for reasons that aren’t exactly clear to the Fed or market players. In response, the Fed in June raised that rate by just .2 percentage point despite raising its target for the federal funds rate by .25 percentage point.

“The spread between the effective federal funds rate and the rate of interest on reserves could continue to narrow over time as the Federal Reserve’s securities holdings and the supply of reserve balances gradually decline,” the report said.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net;Christopher Condon in Washington at ccondon4@bloomberg.net

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Alister Bull, Randy Woods

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