Nothing Normal about this “Normalization”

July 26, 2016 9:00 AM

The US Federal Reserve will almost certainly leave interest rates unchanged at its July meeting.  If so, it will be the fifth consecutive meeting at which the Federal Open Market Committee (FOMC) has declined to raise the federal funds rate. When rates were first hiked last December, the Fed envisioned four additional rate increases this year as part of a process of so-called “normalization” of interest rates after a lengthy stay at zero. Now, while two hikes this year are possible, one rate hike is most likely. By normalization, the Fed means the policy interest rate eventually returns to a level consistent with maximum employment and price stability over the longer run. But as has been the case during much of the recovery from the Great Recession, there will be nothing normal about this process of normalization.

Prior to the December rate hike, the Fed explained that a tightening of monetary policy was required at that time to avoid the risk of an overheating economy that might later force more abrupt rate hikes. Rapid hikes could entail greater financial turbulence and heighten the risk of recession. The Fed now appears willing to take that risk. Why? For one, the Fed was overly optimistic about the underlying strength of the economy at the end of last year. Officials expected a noticeable step up in growth to about 2 1/2 percent even with those four additional expected increases.  But the United States still seems to have a 2 percent economy, despite no rate hikes this year instead of four. This simply is not a “hot” economy bursting at the seams and in need of monetary restraint.

While two hikes this year are possible, one rate hike is most likely.

Moreover, inflation remains tame. Core consumer prices, which exclude food and energy, have edged up this year to a pace of around 1 1/2 percent, but that likely reflects the waning influence of the earlier appreciation of the dollar and declines in energy costs.  Further increases in underlying inflation will likely be driven by tightening labor and product markets—in the jargon of economists, it will involve moving up the slope of the Phillips curve. But the evidence of recent years suggests that slope is very shallow; inflation does not seem very sensitive to activity. So the risk of rapid inflation to the upside seems limited. To be sure, wages are showing their first real acceleration after a long period of meager gains. But that process should be allowed to proceed for a time, in part to confirm the tentative signs of a pickup. Moreover, with labor’s share of income depressed and profit margins high, faster wage growth will not necessarily translate directly into higher price inflation. Higher wages and greater job availability might also draw some people who dropped out of the labor force back into employment, thereby repairing some of the damage done by the severe recession and slow recovery. The benefits of a hot economy might outweigh the costs of some potential overshoot of the 2 percent inflation objective. The FOMC has not embraced a strategy that deliberately risks overshooting the inflation objective, but there may be more latent support for that approach than has surfaced publicly.

#Brexit has undoubtedly placed one more brick on an already high wall of worry.

Another reason for the Fed's greater caution in removing monetary accommodation is the uncertainty about how far rates will have to rise in order to return to “normal.” In December, the median estimate on the FOMC was that the federal funds rate would rise to 3.5 percent in the “longer run.” At the time of their June meeting, that median estimate had fallen to just 3 percent. So even with the funds rate unchanged since December, the perceived gap between where rates are today and where they ultimately need to be has gotten smaller; this implies that current monetary policy is not as accommodative as previously thought. And the path back to that lower “normal” may itself be shallower for a time. Investment spending in the United States (and other advanced economies) has remained far weaker than can be explained by the usual fundamentals of the economy for most of this expansion. At least a part of that weakness is likely due to a succession of global economic and geopolitical developments that have clouded the outlook and raised business uncertainty.  At this point, the United Kingdom’s decision to part ways with Europe, or Brexit, does not seem likely to have a material effect on the US economy. The trade linkages with the United Kingdom are too small, and the effects on the euro area and thus euro demand for US exports are not likely to be large. But the United Kingdom and the European Union are only in the early stages of the divorce process, and it is possible that markets have swung too sharply from despair to complacency. In any event, rather than working primarily through financial markets, the Brexit influence on the US economy may operate more through a negative effect on uncertainty and business investment. For US businesses that effect is likely to be small, but Brexit has undoubtedly placed one more brick on an already high wall of worry. For the Fed, the magnitude of the effect is unknown, but the sign is reasonably clear.

The risk that overheating would require a more abrupt and risky increase in rates now appears to have taken a back seat.

All that said, the Fed is not on indefinite hold. Interest rates are headed higher over the next couple of years. Growth of 2 percent may not be great, but it is above the current growth potential of the economy, which currently is in the neighborhood of 1 1/2 to 1 3/4 percent.  So the labor market will continue to improve, and the unemployment rate should drift down from its current level of 4.9 percent.  In that environment, inflation will slowly edge back to the Fed’s 2 percent objective. As a consequence, the Fed will continue its abnormal normalization of policy by very gradually raising the federal funds rate—in fits and starts, as dictated by the data, not the calendar. Indeed, whether the Fed intends it or not, the unemployment rate is likely to fall below current estimates of “full employment,” and with a lag, inflation may run above the 2 percent objective for a time. Monetary policy is always an exercise in risk management. The Fed appears to have reassessed the risks in light of recent developments. For the Fed, the risk that overheating would require a more abrupt and risky increase in rates now appears to have taken a back seat to the risk that premature tightening could lead to the economy stalling without having tested the limits of its productive capacity and with inflation still falling short of the 2 percent objective. That looks like a well placed bet.