3-12-17 4:18 PM EDT | Email Article
By Greg Ip
A few months ago, virtually no one expected the Federal Reserve to raise interest rates this week. Now, almost everyone does.
The reason for the shift? The world is looking more normal. And in a normal world, interest rates need to rise. As yet, the path of increases still looks leisurely. Yet a normal world also implies a greater risk that the Fed will respond to good news by stepping up the pace of increases or starting to shrink its large bond portfolio.
In recent years, little seemed normal, and the Fed’s behaviour was decidedly asymmetric: bad news delayed rate increases, but good news didn’t speed them up. Central bank officials began both 2015 and 2016 projecting three to four quarter-percentage point rate increases, and in both years delivered just one, in December.
When the Fed began 2017 projecting three rate increases, many investors assumed it would, once again, drag its feet. Two weeks ago officials put them right with a series of public comments that were the equivalent of slapping the market in the face and screaming, “Wake up!”
Two key factors explain why the increases didn’t materialize as planned over the past two years.
The first was a significant rethink of some fundamental features of the economy. Officials long thought unemployment could comfortably sit between 5.2% and 5.5% without generating inflation. Then actual unemployment fell below that level in mid-2015 and stayed there with no sign of inflation and little of wages picking up. The Fed responded by revising down its estimate of the “natural rate” of unemployment to between 4.7% and 5%.
This meant officials thought the economy still had unused slack even as unemployment fell, weakening the case for higher rates. Now, with unemployment at the lower end of their new estimate of the natural unemployment rate and expected inflation perking up, there is less case for waiting.
Officials also thought two years ago they had to get started raising their benchmark federal-funds rate from near zero because they had a way to go to reach the 3.75% rate appropriate for containing inflation over the long run. As officials turned pessimistic on the economy’s growth prospects, they cut their estimate of where rates are heading in the long run to 3%. That added a cushion in which to delay rate increases. However, two years later that cushion for delay is almost gone.
The second factor which had held back the Fed was a series of shocks: a collapse in the price of oil, starting in 2014; a bout of turmoil surrounding the stability of China’s currency; and a vote in Britain to leave the European Union.
Those events didn’t change where the Fed thought growth and inflation would end up. But officials set rates not just according to their forecast but to what will happen if they’re wrong. Cheap oil, China turmoil and Brexit all raised the threat that growth, inflation or both could slide toward zero and the Fed had precious little ammunition with which to respond. By contrast, they had all the rate ammo they needed if growth and inflation took off. So they chose to err on the side of raising rates too slowly than too quickly.
They are no longer content with that trade-off. As oil prices stabilized and then rose, so did expected inflation. Mr. Trump’s victory has raised the prospect of lower taxes, more spending on military and infrastructure, and a lower regulatory burden on business. Officials haven’t seen enough evidence to mark up their forecasts much. But as Bill Dudley, president of the Federal Reserve Bank of New York said last month, “We do know that fiscal policy is going to move in a more stimulative direction. So … the risks to the outlook are now starting to tilt to the upside.”
This shift in tone is difficult to explain solely with data. Things that once worried them, such as politics, no longer seem to. A year ago, fears the British would vote to leave the EU prompted officials to delay rate increases. Today, betting markets put a higher probability (30% to 40%) that Marine Le Pen, leader of the anti-euro National Front will become president of France in May than they did on Britain voting to leave the EU a year ago. A National Front victory could lead to the breakup of the euro or even the EU, a far more disruptive event than Brexit. Yet no Fed official has expressed concern yet.
Officials seem buoyed by the same confidence that has washed over the market. In her speech on March 3 laying the groundwork for this week’s move, Fed Chairwoman Janet Yellen used words such as “strength,” “growth” and “confidence” more than any other Fed speech since 2010, according to Bianco Research, a financial research firm.
So far, Fed officials still seem content with three rate increases for the year. The acceleration in job creation has been met by rising labor-force participation, evidence of more slack and less inflationary pressure than the low unemployment rate implies. Oil prices have recently dropped, which could weigh on both inflation and business investment.
Still, now that Fed officials have put equal weight on upside and downside risks, the clear message for investors is that any good news they celebrate in coming months comes with an asterisk: it raises the odds of tighter money.
Write to Greg Ip at greg.ip@wsj.com