The Fed Punts the Ball

September 18, 2015

On Thursday the Federal Reserve Open Market Committee announced it would keep the target Fed Funds rate at a target between zero and 1/4 percent (0.0% to 0.25%, the so-called Zero Interest Rate Policy, or ZIRP.) In short, they punted. Rather than run with the ball themselves by letting interest rates begin to rise as they have long said will one day happen, the Board of Governors kicked it to the market and elected to play defense. Putting it mildly as possible, we may interpret yesterday’s statement that the Fed would prefer to respond to upward interest rate pressures, rather than to initiate them.

Reasons for Inaction

The main reason given during yesterday’s press conference for keeping the target Federal Funds rate suppressed at ZIRP was the outlook for inflation. The committee still believes inflation will reach its target of 2.0% over the medium term. However, falling energy prices, the strong US Dollar and an economic slowdown in emerging economies colors their view. The median estimate from the members of the committee is for inflation to run at a 0.4% rate for 2015 and not reach 2.0% until 2018. Translation: insufficient progress on prices.

These inflation rate estimates are somewhat lower than the June 2015 forecast because of a further weakening in energy prices. The Fed still expects inflation to accelerate to a 2.0% rate over the medium term (2-to-3 years.) However, the probability of coming up short is now higher than it was in June.

The second reason given was the employment picture. “While the unemployment rate is close to most FOMC participants’ estimates of the longer-run normal level, the participation rate is still below estimates of its underlying trend, involuntary part-time employment remains elevated, and wage growth remains subdued.”-Chair Yellen’s September 2015 FOMC Press Conference

The committee’s interpretation of the employment picture meshes with monthly labor reports thus far in 2015. However, the picture here appears to be one of ongoing, slow improvement. Not much has changed here over the last three years, so we don’t view this as the driving factor for inaction.

In our recent article, Has the Fed Lit a Fuse on Interest Rates?, we noted that recent stock market volatility could impact their decisions. Chair Yellen noted the recent volatility, but said the FOMC’s decisions would not be based on day-to-day swings in financial markets. However, she did mention recent volatility could put further downward pressure on inflation and restrain US economic activity somewhat.

Our Take

The trouble with a policy of zero percent interest rates and two percent inflation is that it perpetuates a negative real return to savings and subsidizes asset speculation with a built-in positive rate of real return. That is a deliberate disequilibrium, in other words a distortion of the incentives that should guide people’s decisions to save and invest. The school we went to taught us that strains build up when governments bend incentives, and have a way of popping loose eventually.

We think that delaying the onset of policy normalization would tend to compress the time period over which it takes place. In other words, later started, faster done. We think of Donald Trump’s vivid pleading in the CNN debate for smaller doses of vaccine administered over longer periods, rather than the horse-needle approach. Is the Fed loading up the equestrian syringe for a more forceful policy injection later on? What we remember from childhood about such doses is that they are too big for the arm, so they stick it in, er… um… a larger muscle.

The next Fed meeting is in October. Chair Yellen did make a point in yesterday’s announcement to say that this would be a “live” meeting. We take that to mean the FOMC could feasibly raise rates as soon as next month. However, the next meeting from which the Fed would issue updated economic projections is scheduled for mid-December. It would be the last one of those before the election campaign moves into hard-count delegate-selection. After that, political pressures could begin to weigh.

Growth Concerns Prevailed Over Easy Money

Bond prices rose and stock prices fell a bit in the immediate aftermath of the Fed’s announcement. Both of these movements would be consistent with an outlook for economic softness in the near future. In other words, investor sentiment seems to be on the skeptical side. Investors may be in the same posture as the Fed, waiting to see tangible evidence of further growth. If that is so, then the Fed’s continuing easy-money policy may not provide as strong a stimulus as it once hoped.

There is an old saying about central bank interventions. They work like the string on a child’s pull-toy. It doesn’t work to push on the string. The Fed’s accommodative stance has no doubt helped to propel U.S. growth along at a faster rate compared to other developed nations since the 2008-09 recession. Seven years on, however, does the Fed find itself no longer pulling but pushing on the string? A knotty problem, indeed.

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