Fed test: Raising rates without provoking a ‘tantrum’

Since the central bank began preparing to slow down its stimulus campaign, high-profile economists have warned that the Fed risks provoking another “tantrum” when it moves toward raising short-term interest rates, similar to the one it kicked off in summer 2013.

In one paper published in February 2014, a group of economists, including a former Fed staffer and top academics, warned that “[w]hen investors infer that monetary policy will tighten, the instability seen in summer of 2013 is likely to reappear.”

That summer, then-Fed Chairman Ben Bernanke surprised investors by saying in several appearances that the central bank might slow its program of large-scale bond purchases.

Merely by suggesting that the Fed could buy bonds at a slower rate, Bernanke caused what was later labeled the “taper tantrum,” bond yields shot up and stock volatility rose as investors interpreted the move as the Fed withdrawing stimulus.

The disruption set back the Fed’s plans for transitioning away from emergency measures such as bond purchases and promises to keep short-term rates at zero toward more normal monetary policy.

Last year’s paper, written by JPMorgan Chase economist Michael Feroli with three other authors, warned that similar problems could crop up as the Fed moved closer to raising its interest rate target for the first time since 2008.

“Stimulus now is not a free lunch, and it comes with a potential for macroeconomic disruptions when the policy is lifted,” they wrote. Others made similar predictions.

So far, however, the Fed has avoided that trap. At this month’s monetary policy meeting, the Fed removed all remaining promises to keep rates at zero past April. After that, Chairwoman Janet Yellen has advised markets, an increase in interest rates could come at any meeting.

That change has not caused any market disturbances. Bond market prices indicate that investors are betting the first round of rate hikes will come in the early fall. Yet yields on 10-year Treasury notes remain at below 2 percent, lower than they were prior to the taper tantrum, and stock market volatility is low.

The lack of a tantrum is partly thanks to Yellen and other officials’ endlessly repeated assurances, in official statements and public appearances, that they will change policy only as warranted by changing economic data.

In a speech in San Francisco on Friday, Yellen tried to further downplay the significance of the coming rate hike.

“The significance of this decision should not be overemphasized,” she said while laying out her view of the economy and how the Fed will conduct monetary policy in the years ahead. Instead, she explained, the more consequential factors for markets are how quickly unemployment and inflation will return to normal, and how high and quickly the Fed will raise interest rates after the first hike.

With the unemployment rate at 5.5 percent in February, near the level that Yellen and others see as consistent with a healthy economy, interest rates will still be relatively low even when they are lifted above zero, Yellen argued. She and other Fed officials have sought to clarify that the Fed will react to incoming economic data and only raise rates as the labor market and inflation demand.

Some observers are not as sanguine as Yellen about how smoothly the Fed’s efforts to raise rates will go.

“Even if this process is well-managed, the likely volatility in financial markets could give rise to potential stability risks,” International Monetary Fund Managing Director Christine Lagarde warned last week in Mumbai, referring in particular to the aftereffects of volatility that would be felt by emerging market countries such as India and Brazil.

But Yellen and the Fed already have cleared the first hurdle, which was to remove the central bank’s promise to be “patient” before raising rates, a statement included in its past several monetary policy announcements. Minutes of the Fed’s January meeting show that Fed officials, worried about the Fed keeping money loose for too long and stoking inflation, hoped to remove that guidance. It appears that they did so in March without upsetting markets.

And Yellen and other officials are working together in trying to set expectations so carefully that, by the time the Fed does lift its target for short-term rates, the market hardly reacts.

“Too much can be made of the liftoff decision itself,” Federal Reserve Bank of Atlanta President Dennis Lockhart in an interview with the New York Times.

Lockhart, a voting member of the monetary policy committee viewed as a centrist, did acknowledge, however, that “it’s going to be treated as a significant decision and a significant phasing from one period to another. Certainly I think when the historians write about it, it will delineate.”