On the surface, the Federal Reserve’s Federal Open Market Committee (FOMC) decision to raise its policy rates by a quarter of a percentage point Wednesday was unsurprising, as the move had been repeatedly signaled by policymakers and was widely expected by financial market participants and economists.
However, bond markets still sold off in the aftermath of the decision, as traders scrambled to adjust to what appears to be a shifting landscape.
This time, financial markets reacted strongly to the news that the FOMC is projecting three quarter-point rate hikes in 2017 vs. only two in their September forecasts.
Yet, a year ago, the FOMC was projecting four rate hikes for 2016, and the markets basically ignored the Fed’s forecast and, as it turns out, rightly so. Why is it the case that, in contrast to a year ago, the financial markets are taking the Fed’s projections seriously?
The answer is that the case for raising interest rates has gone from merely convincing in late-2015 to overwhelming today. Janet Yellen acknowledged in her press conference that the labor market has returned to something resembling its pre-crisis state, which is another way of saying that the economy has reached (and possibly even moved beyond) the Fed’s Congressionally-directed mandate of “maximum sustainable employment.”
{mosads}Historically, when the economy reaches that point, the Fed’s policy rates should be close to the long-run norm (which the Fed currently pegs at 3 percent).
Perhaps more importantly, a year ago, oil prices were collapsing and consumer price inflation was far below the Fed’s 2 percent target with no reason to believe that it would return to that mark in the near future.
In contrast, today, energy prices are moving higher on a seasonally adjusted basis — oil prices are roughly double their early-2016 lows — and the inflation indicators that the Fed follows most closely are in the 1.5-2 percent range, close to the Fed’s target, and trending higher.
All of this comes before Fed officials fully incorporate into their forecasts the likelihood that the economy will see a boost in 2017 from growth-friendly tax reform and regulatory relief. Most Fed officials, while cognizant of the possibility, are unwilling to incorporate these initiatives into their forecasts until the form of the initiatives and prospects for passage become clearer.
For reference, this week’s move by the FOMC took the federal funds rate target to a range of 0.50-0.75 percent. The FOMC projects that it will move three times next year, which would take the policy rate to a 1.25-1.50 percent range.
However, this would still leave monetary policy in accommodative territory at a time when the economy may have already overshot both of its mandates — on employment and inflation. Recall that the Fed’s estimate for the long-run, “neutral” policy setting is 3 percent, which, in my view, is a little low.
A year ago, financial market participants viewed the global economy as highly vulnerable and inflation as stuck at too-low levels for the foreseeable future. Now, they are taking the Fed’s policy projections more seriously because they are beginning to consider the possibility that growth and inflation could accelerate in a meaningful way.
Thus, market participants are ready to believe that policymakers will actually follow through on their projections in 2017. If inflation continues to rise, the Fed may need to normalize policy even faster than expected.
Suddenly, since the election, the “new normal” has become passé, and a return to pre-crisis levels of growth, inflation, and interest rates seems plausible. Indeed, after assuming for years that the Fed would never be able to raise rates by much, market participants may begin to wonder whether the Fed is in danger of falling behind the curve
Stephen Stanley is the chief economist for Amherst Pierpont Securities.
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