When last we posted, we were making the case that a 25 basis point rise in the federal funds rate, paired with a sufficiently gradual tightening thereafter, was a reasonable hawk/dove compromise for the FOMC. Under our outlook, sufficiently gradual was likely to be a good deal more gradual than the FOMC was predicting, however. Our research suggests that conventional slack-based reasoning doesn’t provide much guidance on inflation, and that disparate confounding dynamics of other variables often dominate. Chinese economic outcomes are one such factor, and we argued that China was likely in worse shape than was generally recognized. For this and other reasons we were projecting that inflation would once again come in below what the FOMC was projecting.
A couple weeks into the New Year, it’s tempting to claim that we nailed it. But that’s not right. With plunging Chinese share prices, oil in the vicinity $30 a barrel and the Renminbi in retreat, 2016 has already been a good deal more dramatic than we could, with a straight face, say we expected.
These developments will inevitably call into question the wisdom of the Fed’s December move. Is the current turmoil the Fed’s fault? Was liftoff a mistake?
We think the Fed’s actions played no central role in the recent turmoil. China’s woes are largely home grown, and the continued spectacular fall for oil prices reflects a complex interplay between new technologies, geopolitics, and a newfound Saudi Arabian willingness to pump with gusto at low prices. None of these confounding elements would look different with a fed funds rate at 12 basis points instead of 36 basis points.
Of course, nobody seriously believes that the 25 basis points alone could matter much—it is what liftoff might imply for the future course of policy that could be momentous. On this front, the FOMC spent much of 2015 trumpeting the nature of the hawk/dove compromise discussed above: liftoff was coming but the rise in rates thereafter would be more gradual than previously anticipated. The message seems to have gotten across: the expected path of rates arguably looked more accommodative at the end of 2015 than at the beginning.
For example, in December 2014, the median FOMC projection had the federal funds rate rising to 0.9%, 2.4%, and then 3.4% over the ensuing three years. At the time of liftoff in December 2015, the comparable projection for 1 year ahead is a bit higher, but rate expectations were the same as or lower thereafter (Table 1). The policy interest rate expectations reported in the survey of primary dealers show the same pattern. If pushing the expected policy rate too high has been a mistake, it was a mistake committed by late 2014 and a mistake that moderated a bit in 2015. There was certainly no tightening shift of a magnitude that might be expected to trigger the problems that may lie behind the recent turmoil.
|Table 1. Federal Funds Rate Projections|
|Years in the future|
Note: Projected federal funds rate (in percent) 1, 2, and 3 years from the survey date in the left column. Taken from the FOMC Survey of economic projections [2014, 2015] and from the N.Y. Fed’s Primary Dealers survey. Rates are the medians across respondants, reflect the midpoint of the target range where appropriate, and are rounded to the nearest tenth.
Regardless of the source of recent distress, liftoff could still prove to have been a major mistake. Once again, 25 basis points are hardly worth discussing. Liftoff could become a mistake, however, if the FOMC felt compelled to stay on a tightening path in the face of evidence warranting a reversal. Policymakers are probably as averse as the rest of us to backtracking from a difficult decision. If the FOMC were to show this aversion while incoming information reinforced what we have seen so far this year, that 25 basis points of reasonable hawk/dove compromise could mushroom toward the sort of big mistake that pundits have been trumpeting.
This ugly outcome seems unlikely. At her December press conference, Chair Yellen was asked how the FOMC would feel about reversing course, and gave the right answer:
I’m not denying that there are situations where central banks have moved too early. We have considered the risk of that. We have weighed that risk carefully in making today’s decision. I don’t believe we’ll have to [reverse course]. But … as the Committee has said, we’re watching economic developments closely, and we will adjust policy in whatever way is necessary to support the attainment of our objectives. [source]
Fed officials across the spectrum have be emphasizing this same line.
Thus the stage is set for a policy pivot if the tone of incoming news does not change. Should this scenario continue looming large, we hope that we get clear direction from the FOMC, and not the version of FOMC transparency in which 17 policymakers transparently express 17 views, leaving policy as transparent as Chinese GDP.
3. To be fair, many critics do say that the Fed has been too tight all along. Without debating this view, our point is that the expected path of policy did not become appreciably tighter over 2015. [back]