Debate about the timing of “liftoff”—a hike of 25 basis points in the federal funds rate—has intensified significantly over the past few weeks, ahead of the Federal Reserve statement on September 17. Market participants are debating whether the initial increase will occur in September, later this year, or at all. Some even go so far as to worry about a grave policy mistake should the Fed raise rates in September. Rarely in my career have I seen so much debate and contention over an upcoming Fed meeting.
Let me first distill the debate, and then I’ll share with you where I stand.
On the one hand…..on the other hand
Based on the U.S. labor market, the case for a September move is extremely compelling. At 5.1%, the unemployment rate is within the Fed’s definition of “full employment,” and job growth remains steady, as we highlighted this summer in a research piece. Expectations of wage increases by American workers are gradually returning to more normal levels despite currently lagging actual pay gains. The labor market is not yet overly tight, but it is tightening.
Unfortunately, this is not an easy call to make, as the case against a September move is also very reasonable. The most prominent argument is that core inflation remains stubbornly below the Fed’s long-run 2% target rate into a third year. The recent tightening in financial conditions—primarily the further drop in commodity prices, reduced inflation expectations, and further appreciation of the U.S. dollar—may make policymakers not as “reasonably confident” as they would like to be that core inflation will soon return to a more normal 2% pace. It is the low level of inflation, not recent volatility in the stock market, that those in the wait-and-see camp should point to for the Fed’s holding off. Being concerned about market volatility is one thing; suggesting the Fed be captive to it is something else.
‘Dovish tightening’
In weighing all of the data and risk factors, I’m still in the September camp. Whether I am proved right or wrong, I am sure it will be a close call, perhaps even without a unanimous decision. It would not surprise me if the Fed moved rates up by a smaller increment (perhaps 12.5 basis points rather than 25). Either would clearly emphasize our view that this tightening process will be dovish, given the fragility in global growth in an environment when most other major central banks are contemplating further easing measures.
Regardless of when the Fed decides to act, the more important question has to do with the velocity of the ascent and the cruising altitude that interest rates reach after liftoff . . . or should I say takeoff. In other words, more important than when the Fed starts is where it stops!
During the last tightening cycle, which ended in 2006, the federal funds rate went from 1% to 5.25% in just two years. The current tightening cycle should prove very different, as we discussed in our 2015 global economic and investment outlook. Indeed, we shouldn’t expect a vertical liftoff but rather a much more gradual ascent (perhaps as low as 1% in the first two years), as well as a much lower cruising altitude (a terminal rate of 3% or lower) than some are anticipating, including the Fed. Should our view prove correct, U.S. long-term interest rates and bond prices may not react as negatively as some investors fear.
As part of this gradual tightening, an extended pause, perhaps at 1%, makes a lot of sense. For one, it would mark a removal of some of the policies exercised by the “exigent circumstances” during the financial crisis. It would also give the Fed the chance to reassess how some of the new instruments it has at its disposal are operating and how economic conditions are responding after the historic move off the zero floor. Most important, it will ensure that the federal funds rate remains well below the level of inflation at least through 2017. The global economy is strong enough to warrant takeoff but may not be strong enough to take on a positive real federal funds rate just yet, given such divergent monetary policies.
So, whether rates are raised at this meeting or later this year, we should expect a much lower cruising altitude for the federal funds rate than in previous tightening cycles, achieved with more measured and staggered rate increases than in previous flights.
Although I may qualify this as a “dovish tightening,” I will ultimately view a decision to raise rates as both prudent and welcome following six years stuck at the zero bound. And it will again be a testament to the resiliency of the U.S. economy and its people.
This article was written by Joseph H. Davis, Ph.D., a principal, Vanguard’s global chief economist, and global head of Vanguard Investment Strategy Group.