First Lift Off in the History of U.S. Monetary Policy
(Editor’s Note: Art Hogan, Wunderlich Securities, Inc. Director of Research & Chief Market Strategist, offered the following commentary about the Fed’s move this week to raise interest rates.)
Seven years ago, the Federal Open Market Committee made the historically unprecedented move of targeting the zero bound for the federal funds rate. Obviously, that means that today’s first announced rate hike in nine years is also the first time this key benchmark interest rate has ever lifted off zero.
Neither the current Chair nor the Committee members nor the market have any historic precedent in this country of whether this lift off will be effective, or if it will fizzle. We observe that the number of central banks globally that have been able to leave the zero bound stands at, well, zero. The Bank of Japan (BOJ) tried in 2006, followed by Israel, Canada, Sweden, and the European Central Bank; each of these have returned to rates lower than where they lifted off (except Canada, which is about 25 bps higher than its lift off in 2010).
The FOMC is not bound to this historic precedent, but there are a number of other factors that appear to be poised to push the fed funds target rate back to zero. Among these factors are: weakness in oil prices, which could head lower before they head higher; credit spreads in excess of 600 bps, which could be signaling potential for a recession; and the fact that no other central bank is currently tightening, in fact, most are accommodating.
With the composition of the voting members of the FOMC turning more hawkish in 2016, we expect the FOMC to increase rates two, possibly three times in 2016, though we are not at all confident that lift off will achieve escape velocity.
- A more hawkish board composition in 2016. In Figure 1, we have compiled the voting members of the FOMC in 2016, and compare them to voting members in 2015. Based on recent speeches and press conferences, we identify each voter as either a dove, moderate, or hawk when it comes to monetary policy. Note that in the case of Lael Brainard, we modified our opinion of her tendency during 2015, and we point out that these labels can shift over time. However, we observe that the voting roster going in to 2016 has a more hawkish composition than 2015. The FOMC is ruled by consensus, and policy statements can have no more than two dissenting votes. During Chair Yellen’s tenure, there has only been one dissenting vote on the policy statement, that of Jeffery Lacker, who dissented to the September 17, 2015, statement, saying that the target rate should have been adjusted higher at that meeting.
- The Case of the Sinking Dots. In Figure 2, we overlay the current dot plot of the FOMC’s projections of the level of the federal funds rate at year end from 2015 to 2018, and also for the longer term. Clearly, the sinking dots project a gradual process of policy normalization, and the range of projections in 2018 has widened from 2.875%-3.875% to 2.0%-3.875%. This is not very surprising, given the path of policy has proven to be a track well below prior projections. During the Q&A session, the Chair stressed that monetary policy was determined by models of inflation expectations that are compared to actual results and modified as needed.
- The most difficult question to answer. We observed that the Chair had difficulty in formulating an answer to the question of whether the so-called transitory influences that are dampening inflation—specifically, the strength of the U.S. dollar and low energy prices—are in fact not transitory, but the result of structural changes in global economies. The Chair stressed that the Committee would not formulate monetary policy in response to factors it feels are transitory, but if—after an unspecified period of time—supposedly transitory factors do not dissipate, monetary policy would respond to structural change.
- Why now? The Chair was asked in several ways, why did the Committee decide to move after seven years at the lower bound. Her answer was simple: the Committee felt the conditions it had established had been met. She made the point that economic expansions do not die of old age, that they more frequently are killed by a central bank that has waited too long to move and consequently has to move abruptly. By moving early and gradually, the FOMC can avoid the abrupt moves that have historically killed off periods of economic expansion.
- Our call: two, possibly three moves in 2016. We think the price of oil could continue to decline and that the U.S. dollar shows little sign of weakness. We expect these factors to continue to mask inflation, though we are mindful that slack in the labor market is contracting. There have been modest increases in hourly wages, though it is too soon to say that they are sustainable. We think these factors will conspire to influence the FOMC to raise once in 1H16, and then possibly in September 2016. That might be enough, though at this point a third hike in December 2016 is possible.
- Going back to the zero bound might be necessary. The lack of precedent in achieving successful lift off is daunting, and the prospect of a stronger U.S. dollar and even lower oil prices offer equally significant deterrents for inflation. The winter of 2015/2016 is off to a mild start, at least in the central and eastern regions, so it remains to be seen if the weather will weigh heavily on first quarter GDP, as it has for the past two winters. Moreover, it appears that oil is less of a temporary factor than the Committee had previously believed, given that OPEC has not been able to staunch Saudi Arabia’s strategy of flooding the market with crude. Even if the FOMC hikes rates three times or more in the next 18 months, we think that over the next three years, the target rate could again be at or near the zero bound. We think that ultimately, policy normalization will be predicated on better alignment of domestic and global inflationary trends.