The Fed does its part to perfection
The Federal Reserve did more than increase its benchmark interest rates by a quarter-point, only the third hike in more than 10 years — it also took an important step forward in a gradual policy transition.
Hoping for what I have labelled earlier a “beautiful normalisation” of rates, the central bank is moving beyond strict data-dependency and becoming more comfortable about leading markets rather than following them. In the process of becoming more strategic and less tactical, the Fed will, and should, shine more of the spotlight on others with responsibility for economic policy.
This includes US policy-making entities charged with fiscal, trade, labour market and regulatory issues, as well as other systemically important central banks, particularly the European Central Bank and the Bank of Japan.
While we need to wait for the release of the Federal Open Market Committee minutes in a few weeks, the rationale for the rate hike and the policy shift is apparent in the statement issued at the end of the two-day meeting.
This was reinforced by the comments at Fed Chair Janet Yellen’s press conference that followed the rate increase; and it is one that speaks to both domestic and international factors influencing the economic outlook and the balance of risks.
With the economy continuing to expand at a moderate pace, the Fed highlighted the improvement in business sentiment and welcomed the further strengthening of the labour market.
Meanwhile, Fed policymakers took comfort in the rise in inflation toward the central bank’s 2 per cent longer-term target. These domestic factors seem to be accompanied by lowered concerns about potential headwinds to the US economy associated with developments abroad.
With that, the Fed’s expected path for future rate hikes — reflected in what is known as the “dot plot,” which denotes individual FOMC members’ projections — reaffirmed forward guidance for two more hikes this year and three in 2018.
The central bankers also delayed detailed consideration of any change in management of its balance sheet, indicating it will continue to hold a large inventory of bonds and asset-backed securities.
Shifting the balance of risks
All this was largely anticipated by recent market commentary, which had scrambled to adjust to the expectation that the rate increase was increasingly likely at the FOMC meeting.
Just over two weeks ago, when facing implied market probabilities of only a 30 per cent chance for a March hike, officials worked in a seemingly coordinated fashion to more than triple that expectation; they did so in an impressively quick and orderly fashion.
While not yet reflected in its economic projections and the associated path for future rates, the Fed is monitoring progress in translating President Trump’s trifecta of progrowth plans (tax reform, deregulation and infrastructure investment) into durable policies. Should the administration and Congress deliver, the Fed would first shift the balance of risks to become more hawkish and then accelerate the timing of its rate increases.
The Fed has been the only game in town for far too long. Fortunately, it now sees a window for an orderly policy normalisation.
But this isn’t a path that it can navigate well alone. The central bank — along with both the US economy and the global economy as a whole — needs other policymaking entities to step up and use the tools better suited for the tasks at hand.