(Bloomberg View) -- Market participants are preparing for the Federal Reserve to raise its forecasts for interest-rate hikes when it releases its Summary of Economic Projections this week. Rather than focus on the projections themselves, pay attention to the risks they imply. Is the Fed more likely to raise rate expectations further as the year progresses, or will policy makers back down to the three rate hikes projected last December? In recent weeks, the Fed has signaled that the former is more likely than the latter.
The case for a gradual removal of financial accommodation remains largely intact. Firmer inflation in recent months gives the Fed confidence that it will meet its 2 percent target within the next year. And the Fed is also fulfilling the other part of its dual mandate: Unemployment is holding steady at 4.1 percent even as job growth picks up steam along with the broader economy. The additional workers arising from increasing prime-age labor force participation both prevent further unemployment declines and, with stagnant wages, undermine claims that the economy is at or beyond full employment.
The economy is in something of a sweet spot for the Fed, but the central bank fears that may soon change. At a minimum, the bipartisan spending package signed into law Feb. 9 should boost growth forecasts for this year and next. Central bankers will nudge up their rate forecasts a notch, arguing that even a slightly faster pace of tightening is still “gradual.”
Still, there are reasons for investors to be cautious about the Fed’s forecast. First, we don’t have much experience with a protracted period of unemployment at these levels. One really needs to go back to the late 1960s to experience an economy with joblessness persistently below 4 percent. That episode ended on a sour note with the beginning of the Great Inflation of the 1970s.
Another cause for concern is that the economy faces more tailwinds the headwinds, as Federal Reserve Governor Lael Brainard recently pointed out. Stronger global growth, a weaker dollar, accommodative financial markets and rebounding business investment may give extra impetus to an economy already propelled by federal tax cuts and spending increases. The risk is that the economy accelerates markedly and quickly overheats.
Brainard described current circumstances as the “mirror image” of 2015-16. But that may understate the situation. Although the economy might still be shy of full employment, back in 2015-16 it was clearly further from that constraint.
What strikes me about this situation is not so much that it suggests the Fed will raise the expected rate path, but that the risks to that path are growing larger and tilted toward a sharper pace of rate hikes. This is especially true if the economy is operating beyond full employment and the tepid wage growth simply reflects slow adjustment lags. If so, the Fed is already behind the curve and any acceleration in growth -- say from the tailwinds that central bankers are warning about -- would lead to additional overheating.
Under such circumstances, the Fed would respond with a faster pace of rate hikes. How fast? In 2016, its expected four rates hikes became just one. Hence, using Brainard’s analogy, the three hikes expected for 2018 at December’s FOMC meeting could become six by the end of the year. Maybe even more.
I don’t think the market is prepared for such an outcome, possibly because it is difficult to communicate the potential for a dramatic shift in policy when the Fed is bound so tightly to the language of gradualism. Central bankers don’t want a repeat of the infamous 2013 “taper tantrum,” when bond markets sold off sharply after Federal Reserve Chair Ben Bernanke hinted that the Fed would soon end its bond-buying program. The Fed already fears that a hot economy will fuel financial instability; it doesn’t want to add to that with policy surprises.
To be sure, there are plenty of reasons that the Fed would remain with a gradual hike path -- fears of overheating and inflation have proved unfounded in the past, and this may continue to be the case. But the Fed is making the case that the path of rate hikes is more likely to rise than to fall. If three expected hikes become four at the next meeting, four could become five in the next projections. If so, we can’t say the Fed didn’t warn us.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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