Fed to markets: you’re on your own
Economists at the Federal Reserve are just as clueless as the rest of us.
In a radically altered statement, which received unanimous support from voting members of the Federal Open Market Committee, the Fed dropped any hint of when it will raise interest rates other than to say it will not likely happen at the FOMC’s meeting next month.
The big change in the statement was the removal of the phrase “the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.” Fed Chair Janet Yellen had previously defined “patient” as meaning that the Fed won’t raise rates until June. That language has been removed for phrasing that more or less says, “we’ll raise rates when inflation returns to 2% per year and we’ve reached full employment.”
We, of course, already knew that 2% inflation and full employment were the Fed’s goals. What Wall Street wants to know is what does the Fed consider full employment to be, and will it raise rates before inflation reaches 2% as a preventative measure? Those questions remain unanswered, and what the Fed will do for the rest of the year is less clear today than it was three weeks or three months ago.
In a very important sense, this is a good thing. Wall Street shouldn’t be complacent. It shouldn’t believe the Fed will be there to bail it out with stimulus each time the market tanks. Furthermore, economists at the Federal Reserve aren’t privy to special information denied to markets. As Yellen explained at a press conference following release of the Fed’s decision and statement: “Economic developments that unfold are uncertain. We can’t provide certainty. Market participants should be looking at the same data we’re looking at.”
The market’s problem, then, is the same problem the Fed has been facing for months now. And that’s trying to understand what a slew of conflicting economic data actually says about the economy. On the one hand, employment growth has been nothing short of spectacular. Wage growth has been tame–but so has inflation–to the point that real wages are increasing, albeit slowly. Furthermore, businesses appear to be increasing their investment in plants and equipment, a critical step for ensuring a real and lasting recovery.
At the same time, real-time data appears to show economic growth is slowing here at home, due in part to a quickly appreciating dollar, which is hurting exports. Growth in the rest of the world is slowing too, while financial instability is haunting many emerging markets.
These data have led to a Federal Open Market Committee with divergent and confusing predictions for the economy going forward. Thursday’s release showed that, on average, the Fed sees economic growth and inflation being slower in 2015 than it did just three months ago. It has also revised down its estimate of the natural rate of unemployment to somewhere between 5.0% and 5.2%. This means the Fed doesn’t think we’ll reach its targets for inflation or employment this year.
Yet, only two members of the FOMC predicted that the federal funds rate would remain near zero by the end of the year. The only way to square this circle is to assume that most FOMC members see the economy continuing to improve throughout the year, despite the troubles abroad and an increasingly expensive dollar tamping down exports. A rate hike later this year only makes sense if employment growth continues at a breakneck pace to the point that the risk of higher inflation becomes unavoidable.
Wall Street, however, disagrees. Both Treasuries and the stock market rallied following the Fed statement, which can only mean that the Street focused on the downgraded growth and inflation projections and saw it as a sign that a rate hike will not come until at least September.
For all it’s talk of forward guidance as a tool for managing the economy, the Fed simply can’t predict the future. When will the Fed raise rates? Yellen claims she doesn’t even know, and this time, she means it.
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