Federal Reserve Chairman Jerome Powell virtually promised last week to hold off on raising interest rates until faster inflation is not just a forecast, but a reality. With this dovish assurance, the Fed becomes less of a threat to the economic outlook — assuming he is able to keep that promise.
With the Fed looking to stop cutting rates, the question naturally turns toward the timing of future increases. The logic for a rate hike is fairly simple. Rising risks to the outlook, predominantly slow global growth and trade policy uncertainty, drove the Fed’s dovish pivot this year. If those risks suddenly ease — for instance, the manufacturing downturn bottoms out soon — then the Fed should look to reverse course and pull rates back up as quickly as they went down.
Powell, however, quashed this idea. He made clear that only inflation “moving up or in danger of moving up significantly” would justify a rate hike. Powell is describing something more than simply inflation reverting to the 2% target. For emphasis, he added that the Fed is “strongly committed to achieving our 2% inflation objective on a symmetric basis.” To achieve the inflation objective on a symmetric basis means a willingness to accept some inflation target such that the average inflation rate is 2%. This contrasts with policy since the target was introduced in 2012. Since then, core inflation has averaged just 1.59%, including 1.67% in September.
If that wasn’t enough, Powell also voiced concern about inflation expectations not rising. Vice Chairman Richard Clarida followed up on this idea, declaring inflation expectations at the “low end of a range I consider consistent with price stability.”
The overall message is clear: The bar to another rate cut is high, but the bar to a hike is even higher. To justify a rate increase, actual inflation needs to be high enough to stabilize inflation expectations at a higher level. That means seeing inflation rates rise above target on a sustained basis. The Fed has tolerated somewhat below-target inflation for years, so it should be willing to tolerate somewhat above-target inflation without rushing to boost rates. The upshot is that markets should anticipate an extended period of fairly easy monetary policy even if inflation drifts above target — and if the Fed keeps its promise.
If a recession is, as it appears, more risk than reality, then market participants can expect stronger economic growth in 2020. This leaves open the possibility that the Fed breaks it promise and makes a hawkish pivot. Even though Powell apparently promised not to raise until inflation reached the Fed’s target in a sustained basis, he did leave plenty of wiggle room when he said a rate hike requires inflation “moving up or in danger of moving up significantly.”
But what would signal the “danger” that inflation may move up significantly? Would the Fed tolerate a 3% unemployment rate, or would that push them into the danger zone? The Fed can also bring out the “low rates foster asset bubbles” story, a narrative that may soon become more interesting with the major U.S. stock indexes having reached new highs.
If the economic soft patch turns while the Fed is on hold, equity prices would likely keep pressing higher. Would the specter of 1998-99 come back to haunt Powell and his colleagues even if inflation rates stays low? There remains a persistent concern that failure to reverse the Asian Financial Crisis-induced rate cuts help fuel the tech bubble. The Fed does not want to see a repeat of that event.
The Fed should not be an impediment to the economy, at least not for the time being. If it stays true to the intention to hold rates low as long as an inflationary surge is not evident, the risk of a rate hike anytime soon is very small. That said, we can’t forget entirely that the Fed can and has made rapid policy pivots such as seen this past year. They could certainty do so again.
Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy’s Fed Watch.