Investors expect the Federal Reserve to avoid repeating a frequent error of the past few years when officials meet in Washington this week to set monetary policy.
Unlike at past meetings, Chairwoman Janet Yellen and other members of the central bank are not expected to hint at a new round of interest rate increases that they later will have to back away from when economic growth disappoints.
Rather than another false start, private-sector economists believe, the Fed is not going to say much at all this week, instead reassuring markets that it will keep low rates in place to ensure that the economy doesn’t disappoint and that inflation will rise definitively toward its 2 percent target, after running low for four years.
Part of the reason for caution is the perception that merely suggesting that the Fed might accelerate rate hikes could itself change the investing and spending plans of businesses and consumers, slowing spending and economic growth and frustrating the Fed’s ambitions for returning to a more normal monetary policy. A special concern is that slow growth in China and other foreign countries, itself influenced by Fed policy, could harm the U.S. recovery.
The Fed is “in a much more opportunistic wait-and-see mode,” said Julien Scholnick, a portfolio manager at Western Asset Management Co.
Waiting would not be an easy call. There are plenty of reasons for the Fed to raise rates from the current target of between 0.25 percent and 0.5 percent.
One is the prospect of swiftly rising inflation. Using some traditional rules of thumb for the workings of the economy, inflation would be expected to soar soon: The Fed is holding rates near zero even as the economy long ago left the crisis status that originally justified cutting rates to zero. Most notably, the unemployment rate is now below 5 percent. “The economy is basically at maximum employment,” Federal Reserve Bank of Cleveland President Loretta Mester said in a speech earlier this month.
But other Fed officials have learned that such signals, which may have been useful in the past, are not reliable guideposts to the current situation.
“There’s something very fundamental happening in how they think about the structure of the economy,” said Steven Friedman, a senior investment strategist for BNP Paribas Investment Partners.
The biggest change is that Fed officials have dramatically changed their view of what “normal” interest rates may be. Whereas, historically, a U.S. economy at near full health might necessitate short-term rates rising to above 5 percent to prevent inflation, Fed officials now don’t see that as a benchmark. Thanks largely to demand for money from nervous investors overseas, interest rates may not rise any higher than 1 percent or 2 percent as the U.S. economy reaches a full recovery.
Yellen and company did not arrive at that conclusion easily.
When the Fed ended its large-scale bond purchase program, known as quantitative easing, in fall 2014, it signaled that it would raise rates by a quarter-percentage point nine times in the next two years.
But economic growth disappointed, which the Fed largely blamed on slowing growth in the rest of the world, especially in China. Slowing growth overseas depressed U.S. growth through a few different channels: Falling demand for commodities crushed U.S. oil production and jobs, while the dollar strengthened, hurting U.S. exporters.
During 2015, the dollar strengthened by 20 percent, against a basket of currencies.
Eventually, the effects of the collapsing price of oil and the strengthening dollar wore off and the outlook improved enough for the Fed to go through with a rate hike, in December. Then, it suggested at another eight rate hikes over the next two years.
The suggestion that the Fed would tighten monetary policy again preceded a strengthening dollar and signs of growth slowing abroad. The Fed was forced to hold off on rate hikes throughout the spring because of fears that a global slowdown or financial turmoil could hurt the U.S. recovery, with Yellen saying that the Fed was offsetting overseas headwinds.
Those headwinds may have been partially generated by the suggestion that the Fed would tighten money, given the dominant role the dollar plays in the world economy. “They’ve realized that their communications contributed to that,” Friedman said.
This time is different, however. In the Fed’s latest projects, officials suggested that they saw only eight rate hikes through 2018 and only 10 total.
Some within the central bank have said that they won’t believe that it’s time to raise rates until there is “convincing” evidence that inflation is going to hit the 2 percent target, in the words of Fed governor Daniel Tarullo. Tarullo explained this month that the economy is not like the economy of the 1970s, when inflation rose out of control.
Taking note, investors don’t expect the Fed to raise rates or hint at raising rates this week. Future prices suggest that the earliest markets might expect the Fed to move is in March.
“The Fed has really gone to a much more dovish framework,” Scholnick said.
