A Muddle Of Mixed Messages From The Fed
Markets don't seem to believe the central bank will follow through on its midyear rate hike.
With more than one million jobs added in the past three months, the unemployment rate nearly one full percentage point lower than a year ago, and rising consumer confidence, the economy is clearly on the uptick. Yet there is a worrisome disconnect between Federal Reserve officials and financial markets about what needs to be done in the near future.
Fed leaders suggest that the Federal Open Market Committee will begin raising interest rates as early as midyear and continue raising them over the next two years. Market expectations, however—reflected in interest-rate futures market prices—call for rate hikes beginning later in the year and far more gradual rate-raising than Fed projections.
This disconnect mainly reflects the clumsy way the FOMC has communicated its outlook and intentions. But Fed policy makers need to align market expectations with their own: Central-bank surprises foment market upheaval, as we learned from the “taper tantrum” of 2013. Here's how the Fed can prevent this from happening again.
First, stop giving mixed signals reacting to each day's data dump. The Feb. 6 jobs report, for example, confirmed the positive outlook for “solid” economic growth and “strong” job gains that was described in the Jan. 27-28 FOMC policy statement. Yet recent speeches and media appearances by Fed Chair Janet Yellen and Federal Reserve Bank Presidents Charles Evans and Narayana Kocherlakota convey an impression that the economy and labor markets may not be healthy enough for a midyear rate hike.
Their statements may be part of an effort to maintain Fed flexibility, but they confuse markets. Far better to emphasize the compelling indicators that point to sustained economic growth. For example, while the GDP report for the fourth quarter of 2014—2.6% annual growth—was slower than the previous two quarters, it was still solid. The job market is stronger than it has been in years, and so are the data for consumption and housing starts.
Second, Fed leaders should clarify the implications for monetary policy of energy prices. Inflation has ticked downward in recent months, with the Fed's preferred measure based on core consumer expenditures easing to 1.1% in the fourth quarter of 2014, down from 1.4% in the third quarter. This decline largely reflects sharply lower energy prices. That's good news for consumers, who are now paying much less for the gasoline and heating oil, which are a significant fraction of household budgets.
Yet some market analysts worry that reduced inflation may be a drag on the economy. This is incorrect. A decline in the price of oil has a one-time effect on the price level and no lasting effect on the underlying inflation rate.
To its credit, the Fed has made this point. But misplaced worries about deflation persist, so the Fed should emphasize that as soon as the transitory effects of the decline in oil prices wears off, inflation should be expected to move back toward the FOMC's 2% target rate. If energy prices remain relatively low, that will be a source of continuing higher economic growth.
Third, the Fed should debunk fears that the interest rates it contemplates will sidetrack economic expansion. Even with a hike beginning in midyear, interest rates would remain very low and still well below the inflation rate, implying a negative real interest rate. Prior rate hikes in similar circumstances in 1994 and 2004 did not throw the economy into recession.
The Fed should explain that an increase in interest rates at this stage of economic expansion would help to sustain healthy, balanced economic growth and avoid fueling asset-price bubbles. Such a statement would restore faith in the Fed's commitment to price stability.
Fourth, Fed officials should remind markets that monetary policy takes time to work its way through the economy—what Milton Friedman famously referred to as “long and variable lags”—and on inflation. By holding interest rates close to zero since 2008, and expanding its balance sheet enormously, the Fed already has provided unprecedented monetary stimulus.
M2, the broad measure of the money supply, has been growing at rates in excess of 6% since 2011. As the effects of this sustained monetary growth continue to be felt, and as banks transform their idle excess reserves into new loans and deposits—a process that is well under way—inflation undoubtedly will rise.
By referring to these lags more frequently in their public statements, FOMC officials could express more clearly their confidence that the cumulative effect of past policy actions will bring inflation back to the 2% target. They could also explain, with reference to the same long and variable lags, that the interest rate increases planned for mid-2015 are intended to prevent future inflation from overshooting that target, setting the stage for prolonged economic growth and prosperity.
This piece originally appeared in Wall Street Journal
This piece originally appeared in The Wall Street Journal