After the Fed

The Federal Reserve today delivered exactly what was expected: a liftoff in interest rates from the zero lower bound, coupled with strong assurances that the future rise in interest rates will be moderate. Markets reacted hardly at all to the statement and Janet Yellen’s press conference, beyond a bit of short covering, by and large seeing the decision as a comforting first step towards normalization at a time of significant global tensions. In sum:

• The Fed raised the target for the fed funds rate to 0.25 to 0.5 percent, increased the discount rate (the primary credit rate) to 1 percent, slightly revised downward its economic outlook, and released a statement that was comfortably dovish.
• The participants’ projection for interest rates (“the dots”) suggests perhaps 100 basis points in rate hikes in 2016 and that rates will remain below 3.25 percent through 2018.
• There also was an implementation note that built on previous releases and explained how the new target will be reached through payment of interest on excess reserves and repo facilities that reflects the detailed preparation that went into the decision and should provide confidence that market liquidity will be smoothly managed.

The overall message was that monetary policy will remain extremely accommodative and supportive of a continued economic expansion in the United States. Four broad challenges await though if the Fed is to sustain this optimism.

1. You can’t communicate what you don’t know. The Fed has done a poor job communicating this year, contributing to market volatility and at least temporarily weakening its credibility. In September, for example, within a few days the Fed’s statement, Janet Yellen’s press conference and her speech at the University of Massachusetts arguably provided three different messages about the risks (including importantly international risks) and conditions for liftoff. Adding to the confusion at that time was the perception that the Board was divided on the timing of liftoff, divisions that may well persist with the change in voting members in 2016. But the more fundamental point in the Fed’s defense is that at a time of economic uncertainty, it is hard to credibly precommit to a certain policy path when you are explicitly data dependent. And yet an accommodative policy depends importantly on credible forward guidance on policy. Traditional macroeconomic relationships (e.g., labor market measures and the Phillips curve) have over-predicted inflation in recent years, and there is a substantial debate over whether this represents a temporary or more persistent failure of the models. The current positive pricing in markets reflects a belief that the inflation will remain muted. It doesn’t require an inflation spike, only some evidence that such relationships again have predictive power, to create significant market volatility.
2. A high risk of market turbulence.  It is easy to argue that markets in 2016 will face higher policy and geopolitical risks than they have for some time: China, emerging markets, and populism and anti-union pressures in Europe to name a few. As many have noted, the beginning of Fed normalization at a time when the European Central Bank (ECB) and Bank of Japan are still easing introduces a period of policy asynchronization that traditionally is associated with greater market volatility, especially for exchange rates.
3. Emerging markets remain a central concern. There is growing concern about growth and financial fragility risks in emerging markets, against which continuing capital outflows creates an additional global uncertainty.  The Fed has made clear in recent months that international uncertainties have weighed on their decision making (though expressing confidence that those shocks would have a lessening effect on U.S. activity over time), and Janet Yellen’s press conference comments emphasized her commitment to communicate carefully their plans to avoid spillovers to other markets. I do not believe that there is a credible argument that the Fed has under-accounted for these external risks. Still, this may be the major uncertainty for the outlook.
4. End of an era?  Since the start of the Great Recession, monetary policy has carried most of the burden of support for economic activity. Now that is coming to an end, reflecting not only the Fed’s decision but also a growing skepticism about the power that successive rounds of quantitative easing programs have on industrial economies. An increase in interest rates does provide some scope for rates to be lowered in the face of future adverse shocks, but the benefit of returning to zero is limited. One does not have to fully subscribe to secular stagnation theories to believe that fiscal and structural policies will need to take more responsibility for growth in the period ahead.