Fed Has Another Groundhog Day On Rates

Yesterday, the Fed released its statement at the conclusion of the Open Market Committee meeting where they held rates steady as expected. The Fed also basically took a July increase off the table and the number of Governors who expected two increases by the end of the year dropped, another indication of the Fed backing away from its stated intentions. But the statement and their projections still show this innate faith that inflation will magically return to the 2% level by 2018 which flies in the face of the market’s inflation expectations.

In a piece that you should read in its entirety from the Washington Post the other day, Larry Summers makes the case that the Fed continues to make the same mistake again and again. He states, “Watching the Fed over the last year there is a Groundhog Day aspect. One senses they really want to raise rates and achieve a more ‘normal’ stance.  But at the same time they do not want to tighten when the economy may be slowing or create financial turmoil. So they keep holding out the prospect of future rate increases and then find themselves unable to deliver. But they always revert to holding out the prospect of rate increases soon, partly for internal comity and partly to preserve optionality.” And this is exactly what we saw yesterday, as the Fed keeps on holding out the prospect of a rate increase but then ends up having to back away because the data does not support it.

Summers also points out that the odds of a recession in an economy that is well out of recovery are starting to grow and the neutral rate of interest has also declined over the last few years. In fact, his theory as to why future inflation expectations are so low is precisely because they are factoring in an economic slowdown in the next couple of years. Stagnating growth around the world and political uncertainties (Brexit, Trump) also play into this.  All this begs for inflation target well above the 2% range. And if that is the case, that calls for the Fed “to signal its commitment to accelerating growth and avoiding a return to recession, even at some cost in terms of other risks”.

Each time the Fed backs away from another proposed rate increase and let’s its 2% inflation projection stand in the face of declining inflation expectations, it is another blow to Fed credibility. But, even worse, it makes it even more clear that the Fed is fighting the wrong battle, continually looking to slow down non-existent growth instead of promoting policies that encourage even a little too much growth.