Fed Holds Rates, Signaling Caution on Outlook

by: Cliff Waldman, Chief Economist 

Stating “near-term risks to the economic outlook appear roughly balanced,” the Federal Open Market Committee (FOMC) elected to keep the target range for its influential federal funds rate between 0.75% and 1%, after a 25 basis point hike at the March meeting. The paradigm of caution that has guided monetary policy since the end of the deep 2008-2009 recession clearly remains in place, even as financial markets expect further monetary tightening as soon as June.

Amidst the Fed’s balanced assessment on the outlook, contradictions and complexities abound. This is due to the unknowns of short-term economic data, and partially due to the unpredictable nature of post-economic crisis years. U.S. GDP growth slowed to a paltry 0.7% during the first quarter of 2017. However, it was partially due to a slowdown in consumer spending that could have been a correction from outsized activity in recent quarters. In the same report, we learned not only of a much-needed acceleration in business fixed investment activity but also of an improvement in export growth. This adds to mounting evidence that U.S. manufacturing is finally seeing somewhat better days after years of economic weakness.

The greater complexity for the outlook and conduct of monetary policy, however, comes in the understandably strained effort to make sense of the labor market. The labor market appears to be at full employment, coexisting with an inflation rate that is still not convincing the FOMC that it has crossed the much-desired 2% level. The large body of research flagging the importance of the 2% inflation rate is clearly influencing monetary policy thinking. The intervening factor is the labor force participation rate. It is simply incorrect to argue that the U.S. labor market has reached a the unemployment rate that is roughly consistent with full employment (below which accelerating inflation becomes a problem), when the participation rate, in spite of very modest firming indicators in recent months, remains at a near four-decade low. If the U.S. had anything even close to a historically normal labor force participation rate, the unemployment rate would be measurably above its current level, and not many would argue that we have reached full employment yet.

Further constraining aggressive monetary action, the Fed, like many other major central banks, is jaded by the uncertainty of recovery from a near financial collapse that followed years of damaging deflation threatening the U.S. and global outlooks. Apart from the data and the research, a gut level sense of concern is not going to leave our skilled monetary policymakers just yet, even as the world shows signs of better days to come.

Financial markets will get their expected interest rate hikes. But they will get them slowly and in fits and starts. Like so many things in the wake of the epic events of 2008 and 2009, monetary policy is different this time.