Liftoff? And then…

By: Jon Faust

December 15th, 2015 5:48 pm

Early December finds us asking the traditional question on the eve of the holidays: What will the Fed give us for interest rates next year? Holidays past might provide some guidance. The Fed’s policy projections going into the December FOMC last year showed a year-end 2015 median federal funds rate of about 1.5 percent, with a range from zero to three percent. And the situation is almost the same this year: the funds rate is zero entering the December meeting, and the projections for year-end 2016 have a span of approximately zero to three percent, with a median just below 1.5 percent. More Groundhog Day than Christmas.

So what rates will the Fed give us next year? According to one popular narrative, each FOMC meeting over the next year will showcase hawks against doves in a pitched battle. In this story, the key issue is whether this is finally the year that the hawks score a knockout blow—rates stay at zero until that blow is landed. This storyline may be as close as monetary policy will ever get to reality TV, but this isn’t how policy is made.

Let me sketch a different view. The main distinguishing feature across policymakers is not the passion they have for high versus low rates, it is what they see as the most likely scenario. For the hawkish faction, the extraordinary accommodation that has long been in place is causing—or at least planting the seeds for—distortions and excesses, including inflation. In the main dovish scenario, growth remains modest and inflation continues running very low, raising the risk that any adverse development might be sufficient to push the economy into a pernicious deflation and require the Fed to dip deeper into the bag of unconventional tools. The FOMC is, I believe, agreed on two things: first, if stronger evidence of excesses arose, the FOMC should and would act promptly; and second, being forced to dip back into the nontraditional toolbox—à la the European Central Bank and Bank of Japan—would be bad.

So which scenario will drive policy next year? Neither. Or both.

The FOMC doesn’t need to embrace a particular year-ahead scenario. Instead, it positions policy in light of the diverse opinions about what is likely, and then adjusts policy as conditions evolve and the relevant scenario reveals itself. Consider the position a year ago at this time, when the median year-ahead projection had the funds rate just below 1.5 percent. At that time, many commentators argued that the Fed had a credibility problem because the private sector seemed to expect lower rates. This view reflects a misunderstanding of how the FOMC projections work.

Each policymaker makes a projection premised on what that individual believes is the most likely scenario. Thus, the 3.0 percent funds rate projection posted a year ago essentially answered the question, ‘What should the Fed do if inflation and/or growth take off?’ Similarly, the zero percent rate projections answered the question, ‘What should the Fed do if inflation and/or growth falter?’ The way the projections are reported greatly obscures this fact, because we are not told what scenario goes with which policy rate. We can make sensible guesses however.

Suppose that the 3.0 percent rate projection a year ago were paired with the highest projected core inflation rate of 2.4 percent and the highest growth projection of 3.2 percent. This would imply a real federal funds rate of 60 basis points with robust growth and high and accelerating core inflation. In this case, I could readily imagine hawks and doves (happily) haggling over rates well above 2.0 percent. Calling this the most likely scenario was not credible in my view—to me, this scenario was freakishly unlikely—but the policy linked to the outlook seems sensible.

The 2015 example reminds us that all those ‘What ifs’ reported in the FOMC projections don’t much matter for policy: the FOMC positions policy in light of the dramatic spread of opinion, and then responds as reality unfolds. During 2015, it fairly quickly became clear that both growth and inflation would be weak; indeed, it now looks like both growth and inflation may fall below the entire range projected by both hawks and doves. The doves didn’t smack down the hawks; instead, the dovish ‘What if’ happened.

For next year, the FOMC has once again been positioning policy in light of a wide diversity of views, but most all of the FOMC participants seem to see considerably less slack in the labor market than at this time last year. Most have suggested that another year of extraordinary accommodation may have increased the risks emphasized by the hawks. By raising the federal funds rate now, the FOMC may counter some distortions and will make future rate increases less fraught should the hawk’s scenario come to pass. But raising rates inevitably entails some drag on Main Street, drag that is particularly worrisome in the main dovish scenario. In deference to these risks, the FOMC has been making clear that rates will rise slowly so long as the economy continues to navigate between the cases emphasized by hawks and doves. Not ideal for anyone, perhaps, but a sensible approach.

And where will rates end up? I take the FOMC rate projections very seriously as ‘What if’ statements. But the median FOMC member has (incorrectly) envisioned growth and inflation picking up as the relevant ‘What if’ for several years. We have not yet seen the December projections, but my own view is that this regularity is likely to continue. If so, we’ll get a prudent liftoff that is again followed by considerably slower rate increases than those reflected in the median FOMC rate projections.

What I’d most like for the holidays, of course, is for those projections of solid growth and accelerating inflation to come true, in which case we’ll all be toasting better times and more normal interest rates next holiday season.

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