5^th February 2018

By Steven K. Beckner

Not long ago stronger economic conditions and easing financial conditions -- soaring stock prices, indefatigably low bond yields and a weakening dollar -- were combining to make many Federal Reserve officials more inclined to raise interest rates. Offsetting that tendency were stubbornly slow wage gains and below-target inflation. But lately those two sets of conditions have flipped dramatically. And while Fed policymakers are reluctant to rush to judgment and lurch toward a more aggressive (or less "gradual") path of rate hikes, the Fed calculus is changing. What a difference a couple weeks can make. A week after passing 26,000 and three weeks after passing 25,000 for the first time, the Dow Jones Industrial Average made it two thirds of the way to 27,000 as it rose more than 2% in the week ending Jan. 26. The breathtaking rally owed much to improved economic prospects, reinforced by tax cuts, but also had a lot to do with inordinately low long-term interest rates. As the year began, the 10-year Treasury note yield was barely above 2.4% and anxiety about an "inverted yield curve" was rampant. The dollar plunged to a three-year low. Monetary policy affects the economy by affecting financial conditions, but feedback from financial markets can in turn affect policy. Struck by the failure of five federal funds rate hikes to tighten financial conditions, some frustrated officials confided a willingness to raise rates faster to reduce overall accommodation. Then things changed. The 10-year yield went above 2.6% on Jan. 18, reached 2.7% Jan. 29 and hit 2.85% Feb. 2, even as the Federal Open Market Committee kept the funds rate in a 1.25% to 1.5% target range. With that, the long-awaited stock sell-off commenced. Last week, the Dow plunged 4.1%. The S&P 500 fell 3.85%, and the Nasdaq Composite 3.5%. The selling was ongoing as this was written. Suddenly, financial conditions are looking significantly less accommodative, and to the extent this new trend is sustained it could influence the funds rate path Of course, we mustn't lose sight of the fact that the stock sell-off and run-up in bond yields were triggered by positive news on growth, jobs and wages. Sluggish wage growth has helped keep the FOMC on a gradual rate hike path. But with labor markets tightening, average hourly earnings rose 2.9% from a year ago last month -- fastest pace since the recession. Other labor compensation measures are also accelerating. Firms are having to pay more to land scarce skilled workers. San Francisco Federal Reserve Bank President John Williams says wages are "ratcheting up" and will lead to faster price increases. The Fed has long thought yields were too low, that stocks were "elevated" and that it was only a matter of time until tight labor markets bred wage-price pressures. So there is no contradiction. The Fed is finally getting what it has long predicted, indeed hoped for. On net this new constellation of forces tends to support more tightening -- unless the selling on Wall Street cascades into economically damaging financial instability. But it would me unrealistic to think the FOMC will get carried away with removing accommodation. There are moderating influences. For one thing it seems unlikely inflation will greatly overshoot the 2% target, and a certain amount of overshooting would even be welcomed, particularly among advocates of price level targeting who argue for a "make-up" of past inflation shortfalls. Anyway it will take time for fundamental changes to manifest themselves and be recognized by the FOMC. Policymakers will be slow to alter base assumptions about GDP potential, NAIRU and the neutral rate. The FOMC will also consider the putative negative "wealth effects" of the market drop, although officials disagree about the time frame over which consumer behavior is affected. Besides, not even the most hawkish officials want to raise rates so fast they jeopardize the expansion. After Friday's employment report, Williams, an FOMC voter who is in the running for Fed Vice Chairman, said "we need to continue on the path of raising interest rates" to "reduce the risk of us getting to a point where things could overheat." But he tamped down fears of more aggressive moves. "I don't see an economy that's fundamentally shifted gear," he said, adding that raising rates too rapidly (or too slowly) "could knock the expansion off track, and that's the last thing I want to see happen....I expect continued moderate growth, with no Herculean leap forward. So given that the economy's performing almost exactly as expected, you can expect policymakers to do the same." At most, the FOMC might raise the funds rate four times instead of the three it projected in December, and that doesn't seem like anything to get too riled up about.