The Fed Takes Confusing Path to the Right Place

March 22, 2016 12:00 PM

The message delivered by Janet Yellen and the Federal Reserve last week—in the statement from the Federal Open Market Committee (FOMC), the economic projections, and at the press conference—was a confusing one. Chair Yellen described the forecast as not having changed much since December. But the median path for policy interest rates was marked down by 50 basis points this year and next, and despite that lower path for policy rates, the Committee still reduced their projections for the growth of real GDP over this period. This all adds up to a sizable downgrading of their economic outlook since the December meeting.

Such a large adjustment to the forecast would have been understandable a month or so ago, when equity markets were swooning, volatility spiking, and the dollar strengthening. Yet the reversal of much of that turbulence in recent weeks has left financial conditions nearly unchanged, on net, since the December FOMC meeting. And the downgrading of the global economic outlook, cited by Yellen at the press conference, has been too small to explain the revision in the FOMC’s economic outlook.

The one notable area where there have been genuine surprises in the incoming data has been inflation, where two consecutive readings on consumer price inflation have outstripped consensus expectations—and very likely the Fed’s. Nevertheless, the median projections from both total and core inflation are slightly lower than in the December forecast. So this set of projections for growth and inflation are difficult to square with the data and developments that have occurred since the FOMC’s December meeting.

The Committee once again declined to characterize the balance of risks to the economic outlook. This reluctance also is a bit difficult to understand. To be sure, there have been times in the past when economic and financial developments were moving so fast and uncertainty was so great that characterizing risks—or reaching a consensus on how to characterize those risks—was not easily possible. But this is not one of those times. The FOMC faces at present a confusing collection of data and strong crosscurrents in economic and financial forces—as is always the case. , The only risks cited in the FOMC statement were those associated with global economic and financial developments, strongly suggesting that the downside risks figured most prominently in the Committee’s thinking. However, at the press conference, Yellen stressed that the risks had diminished and were two-sided (also always the case). She cited upside risks associated with recent stimulus measures undertaken by China, the euro area, and Japan. This seems a bit of a stretch, given that these actions were undertaken largely out of concerns about the weakness in economic activity and low inflation in these economies. She also noted the recent rebound in oil prices and its likely positive effects on energy firms and some oil-producing economies. But prior Fed communications and much economic analysis would have led one to believe that higher oil prices, on net, would be a negative, not a positive for the US economy. In brief, the communications surrounding the March meeting will not likely enter the Fed Hall of Fame, though I would quickly add that, compared with some notable episodes in the past few years, neither will these communications enter the Fed Hall of Shame.

All that said, Chair Yellen and the Committee have gotten to the right place—and a place the Chair might have been more comfortable with back in December. I suspect that she sees the risks of going too soon too fast as greater than those going too slowly too late. The events of January and February, which probably created many sweaty palms for FOMC members, helped build support for a presumption (not a promise) of an even more gradual increase in rates than was envisioned in December. The downside risks to the outlook may not be much greater than the upside risks, but the costs associated with downside outcomes would be substantial. To be sure, the FOMC will face a more difficult policy decision in coming months if inflation pressures are in fact mounting. But Yellen is right to note that it is too soon to arrive at the conclusion that wages and prices are indeed accelerating. And evidence that inflation expectations and inflation compensation are retracing some of their recent softening would be reassuring on that score.

Did concerns about the strength of the dollar dominate the policy conversation? The dollar has likely played an important role in the Fed’s thinking about the overall tightening of financial conditions, as well it should. And the FOMC undoubtedly anticipated its post-meeting communications would weaken the dollar, at least initially. And there’s nothing wrong with that. But the dollar is just one of the channels of monetary policy that officials consider in reaching their decision. The Fed is not “targeting” the dollar. Interest rates, credit spreads, equity prices, and exchange rates are all parts of the policy transmission mechanism. The dollar is just one of the channels on the dial.