The Fed can’t cope with uncertainty anymore!

28 Jun 2016

The FOMC kept rates steady last week. Heavy on Governor Yellen’s mind was the lack of a consistent data narrative showing a healthy pace of US growth. This time around, it was mostly May’s soft non-farm payrolls report, but also, arguably, the possibility of severe market disruption related to Britain’s EU referendum that stayed the hand of the Yellen Fed. However, there appears to be a lengthening list of uncertainties to which the Fed pays close attention. It is so concerned that its miniscule and long-heralded funds rate increase will be disruptive to economic progress and financial market stability that the threshold for deferral is painfully low. An institution that once acted with independence and impunity is increasingly neurotic and deferential to global events and risks.

Fed officials have made it clear that they are deeply uncomfortable with the current level of US interest rates. The possibility of an economic downturn over the next 2 years – given the length of the current expansion – and its inability to ease policy meaningfully at already low levels of interest rates, is making FOMC members increasingly fretful. Yet they remain extremely cautious about the timing of policy normalisation.

The principle guiding that caution relates to the perception of asymmetric risk in respect of the possible damage of tightening prematurely versus the possible damage of tightening late. The reasoning is as follows: increasing interest rates when the economy is still actually unable to cope with a higher cost of borrowing would bring it back to its knees, and the central bank would find itself with very little scope for active intervention. On the other hand, if it kept interest rates too low relative to where they should be, a burst of inflation would likely materialise. The disposition of most committee members is that it is very straightforward to deal with that second instance: it has merely to raise the policy rate in order to bring back inflation to target. Contrariwise, it is extremely difficult to support a struggling economy if room for conventional interest rate policy is very limited, as Governor Bernanke found out in his post-financial crisis years at the helm.  
The issue is whether the threshold for what might constitute a risky move has increased meaningfully because of an increased sensitivity to global developments. A subtle shift seems to have taken place last year. At a press conference in September, Chair Yellen referred numerous times to concerns regarding China’s growth prospects as one of the reason for keeping its benchmark interest rate at 0%, despite her stated intention to normalise interest rates. This is in stark contrast to a world gone by when Fed officials would barely mention global phenomena in its monetary policy statements. If they did invoke external factors as key inputs in monetary policy making, it would happen in the context of fully-fledged crises. While one could argue that worries about a structural decline in China’s growth rate had already been rattling financial markets, the speech marked an important change. Now, the Fed changes course on the mere perception of increased uncertainty in distant places.

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