Has one FOMC member just admitted the Fed doesn’t need to raise rates for the next two years?
While financial market participants waited in anticipation for the UK referendum, another FOMC meeting came and went without the Federal Reserve raising the federal funds rate. Since the Fed began the process of raising rates in December 2015, they have yet to make a second move in the subsequent four meetings. This is not the first time the Fed has had to push back its time table for raising rates. Although the timing of the first rate hike had been debated for nearly 3 years, the committee appeared to unanimously agree that once the first hike was “out of the way”, multiple interest rate increases would be appropriate in each of the years following the start of the normalization. Now, the tide may be shifting.
At the June FOMC meeting, one member admitted that they only saw one rate hike as appropriate through the next 2 years and potentially for even longer. If you read the June Summary of Economic Projections closely, you would have observed that one committee member set their future federal funds rate projection as a flat line at 63bps through 2018 and omitted their long-run estimate. That member quickly revealed himself as President James Bullard of the St. Louis Fed.
Despite his forecast for the federal funds rate, Bullard claims he is not a pessimist on the US economy. In fact, he sees the US economy nearing full employment with little output gap remaining.
According to his new paper “The St. Louis Fed’s New Characterization of the Outlook for the U.S. Economy”*, Bullard has concluded that changes to interest rates are not necessary provided the following three conditions remain unchanged:
Against an economic backdrop of low growth and low productivity for the foreseeable future, Bullard sees the relationship between inflation and unemployment (the “Phillips Curve”) as so insensitive that there is no need to tighten policy aggressively even as the labor market improves. Given these conditions, the St. Louis Fed President sees little scope for inflation to accelerate further.
Of course, the risk to doing nothing is that the traditional Phillips Curve reasserts itself. Subsequently, policy would have to react more aggressively. Conversely, the impacts of major political events such as the recent Brexit vote or the upcoming US election could pose recession risks which would certainly alter the regime. One must also consider the risk of asset bubbles, which Bullard’s approach says little about but could pose risks to his flat forecast.
Bullard’s lack of a long run forecast could be seen as admittance that the Fed is no better at forecasting growth in the long-run than a crystal ball. It could also be a subtle nod to Larry Summers’ demand-side secular stagnation theory or Robert Gordon’s pessimistic supply side view of potential growth in a world of aging demographics and less opportunities for innovation.
In this low growth environment, is Bullard suggesting we don’t need any monetary policy tightening in this business cycle at all? Many believe that the unofficial tightening cycle started far before the first rate hike, as the punch bowl looked a bit emptier following the taper tantrum and the subsequent end of QE3. But in terms of a traditional tightening cycle, we have yet to see anything of the sort.
The lack of normalcy in this economic recovery has caused many traditional economic relationships to be questioned. The assumption that we need a traditional rate hiking cycle in this recovery should be questioned, as well. While President Bullard has proposed several policy frameworks during his tenure, Fed watchers should monitor FOMC communications closely as it is possible that other committee members could begin to adopt similar approaches. But until then, the best solution for the Fed appears to be to do more of nothing.