New ab­nor­mal causes Fed to re­think poli­cies

Econ­omy isn’t fol­low­ing mod­els, caus­ing a slow­down in rate hikes

The Buffalo News - - BUSINESS - By Matthew Boesler and Jeanna Smi­alek

Fed­eral Re­serve pol­i­cy­mak­ers have con­cluded that when in doubt, do no harm.

Wel­come to the new ab­nor­mal.

Six months ago, U.S. cen­tral bankers thought they’d soon be re­turn­ing to the days of on-tar­get in­fla­tion, full em­ploy­ment and in­ter­est rates that, while lower than in decades past, would still need to rise into growthre­strict­ing ter­ri­tory to keep things on track.

But in a wa­ter­shed mo­ment, the Fed­eral Re­serve sur­prised in­vestors Wed­nes­day by slash­ing rate pro­jec­tions to show no hike this year. Of­fi­cials sig­naled ex­pec­ta­tions for a slow­down in the econ­omy, which would trans­late into higher un­em­ploy­ment than pre­vi­ously fore­cast, and they no longer ex­pect in­fla­tion to rise above their 2 per­cent tar­get.

The move was a se­ri­ous about-face. Since Septem­ber 2017, they had sig­naled they would prob­a­bly need to even­tu­ally raise rates above their es­ti­mate of the so­called neu­tral level for the econ­omy – which nei­ther slows nor spurs growth – to slow the ex­pan­sion and pro­tect against the pos­si­bil­ity of higher in­fla­tion.

That was based on a long­stand­ing view in the eco­nom­ics pro­fes­sion about how the econ­omy works: If cen­tral bankers al­low the un­em­ploy­ment rate to fall too far be­low its low­est sus­tain­able level by keep­ing rates too low, then in­fla­tion will rise.

But in the U.S., though the un­em­ploy­ment rate has fallen to 3.8 per­cent, near the low­est lev­els in five decades, nei­ther price gains nor in­fla­tion ex­pec­ta­tions have gone up. If any­thing, they’ve been slid­ing. And it ap­pears to be a global prob­lem. The ap­par­ent con­tra­dic­tion has pol­icy mak­ers re­think­ing things.

Here are five key de­vel­op­ments that ex­plain the Fed’s dilemma:

Fed of­fi­cials’ have been try­ing to get rates from just above zero – where they’d held them from 2008 to 2015 – to their es­ti­mate of the neu­tral rate.

When they be­gan hik­ing in De­cem­ber 2015, they be­lieved that num­ber was around 3.5 per­cent. Now they think it’s more like 2.75 per­cent, which means they are get­ting close. But the new pro­jec­tions show pol­icy mak­ers think rais­ing rates to that level over the next three years would be go­ing too far, given re­cent signs of a de­cel­er­a­tion in the pace of eco­nomic growth.

• Don’t look down: Low rates glob­ally mean cen­tral banks in­clud­ing the Fed have less fire­power to counter an eco­nomic slow­down. The yield on 10-year Trea­sury se­cu­ri­ties, at 2.54 per­cent, is only about a tenth of a per­cent­age point higher than the Fed’s overnight rate. Some economists view the Fed’s tight­en­ing cy­cle as now hav­ing peaked, and in­vestors see more chance of a rate cut over the next year than a hike. That has Fed of­fi­cials think­ing harder about

strate­gies to de­ploy along­side rate cuts when the next down­turn hits.

• Price prob­lems: Low in­fla­tion has been a thorn in the Fed’s side through­out this ex­pan­sion, and it’s a big part of the rea­son that the cen­tral bank has cut back its rate-hik­ing plans for the cy­cle.

Fed of­fi­cials say they tar­get 2 per­cent in­fla­tion sym­met­ri­cally – mean­ing they’re equally un­happy about over­shoots and un­der­shoots – but they’ve been on the low side since they for­mally adopted that tar­get back in 2012. The Fed isn’t alone: from Ja­pan to Europe, cen­tral banks are strug­gling to meet their in­fla­tion goals.

De­spite that, the tepid progress has come as a sur­prise to U.S. pol­icy mak­ers, who be­lieved Amer­ica’s hot la­bor mar­ket would push price in­dexes higher, faster. Of­fi­cials had ex­pected in­fla­tion to climb to 2.1 per­cent in 2020 and 2021 – un­til Wed­nes­day. They no longer ex­pect to over­shoot their 2 per­cent goal at all, their new­est eco­nomic pro­jec­tions show.

• Use­less guide: The job mar­ket has con­sis­tently sur­prised the Fed. Amer­ica’s un­em­ploy­ment rate has fallen to less than 4 per­cent from 10 per­cent in 2009. De­spite the de­cline, em­ploy­ers have found plenty of work­ers to hire, gen­er­ally keep­ing job gains strong, and in­fla­tion has re­sponded only weakly.

Why? Em­ploy­ees have been stay­ing in the la­bor mar­ket longer, and more re­cently, wouldbe work­ers have be­gun com­ing in from the side­lines. The share of adults who work or look for work, which had staged a long-run­ning de­cline, has sta­bi­lized. The trends sug­gest that the job­less rate may be los­ing some of its oomph as a pol­icy guide.

Against that back­drop, Fed of­fi­cials have re­vised their es­ti­mates for the un­em­ploy­ment level they be­lieve would be con­sis­tent with sta­ble in­fla­tion in the long run down to 4.3 per­cent – a big change from 2010, when they be­lieved that num­ber was above 5 per­cent. They see the job­less rate bot­tom­ing out at 3.7 per­cent this year, be­fore creep­ing higher.

• Big bal­ance sheet: The Fed’s bal­ance sheet ex­ploded to $4.5 tril­lion from $1 tril­lion on the back of three rounds of post-cri­sis bond-buy­ing. The pol­icy com­mit­tee has grad­u­ally shrunk it to just un­der $4 tril­lion by al­low­ing bonds to ma­ture with­out rein­vest­ing the pro­ceeds. Fed Chair­man Jerome Pow­ell and his col­leagues an­nounced last week that the rolling-off process will start to slow in May and will end in Septem­ber.

Pow­ell said the bal­ance sheet will prob­a­bly close out the process at the end of the year “a bit above” $3.5 tril­lion, a size the cen­tral bank might main­tain for a while be­fore be­gin­ning to grad­u­ally ex­pand its hold­ings again to sat­isfy cash de­mand.

Suf­fice it to say, Fed of­fi­cials are weigh­ing a lot of big ques­tions about bedrock eco­nomic con­cepts. Still, that story – and the cau­tion it calls for – could change if growth beats ex­pec­ta­tions.

“Ev­ery­one is say­ing this a huge dovish pivot,” said Neil Dutta, head of eco­nom­ics at Re­nais­sance Macro Re­search. “I’m not so sure. It’s a fore­cast-de­pen­dent pivot.”

Bloomberg News

Jerome Pow­ell, chair­man of the Fed­eral Re­serve, pauses pro­gram.

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