The Fed’s Lift-Off: Keep Calm and Carry On
Some bond traders were teenagers the last time the Fed increased interest rates.
By Alan S. Blinder
Federal Reserve Chair Janet Yellen at a monetary-policy conference in Washington, D.C., Nov. 12. Photo: Andrew Harrer/Bloomberg News
You’re in a pretty strange place when the phrase “lift-off” evokes images of the Federal Open Market Committee rather than of Cape Canaveral. But here we are, with all financial eyes fixed on the Fed and most market participants expecting the first increase in the federal-funds rate in more than nine years to come on Dec. 16.
Unless the outlook changes substantially between now and then—and we’re barely more than two weeks away—the Federal Reserve will move the target range for the rate up from the present 0-25 basis points to 25-50 basis points. Did Fed Chair Janet Yellen tell me that?
Certainly not. But the Fed has dropped enough hints that only the stubborn remain unconvinced.
In all likelihood, the FOMC is heading for an eventual federal-funds rate near 3.5%. The key word is “eventual.” The Fed is in no hurry and will probably take three years or so. If so, the tightening pace would be roughly 100 basis points a year, which is less than half the average of the previous three tightening cycles (2004-06, 1994-95 and 1988-89).
While the Fed hasn’t addressed this point, it’s also a good bet that the FOMC will not lock itself in to a fixed pace, as it did in 2004-06, when it raised the federal-funds rate 25 basis points at an amazing 17 meetings in a row. One hundred basis points a year translates to 25 basis points at every second meeting, on average. But the Fed won’t be that regular.
Now for the hard questions.
First, how will financial markets react on Dec. 16? Markets seem to have built a 25-basis-point rate increase into pricing and so shouldn’t react much when it actually happens. But markets have proven themselves to be fickle and frequently surprising. Remember: Some bond traders were teenagers the last time the Fed raised rates.
Furthermore, we don’t know what words will accompany the rate increase on Dec. 16, nor how traders will read those words. Ms. Yellen will no doubt seek to be calm and reassuring, repeating the message that the Fed expects to move slowly. But every sentence will have adjectives and adverbs, and who knows how traders—a highly excitable lot—will read them.
I’d assign, say, a 25%-33% probability to an outsize market reaction.
Second, do the details of the interest rate path matter much? Is it important whether the Fed goes up 75, 100 or 125 basis points in the first year—and ditto for years two and three? Well, not unless you are a bond trader betting on the outcome of each FOMC meeting. For the rest of us—business owners, households and so on—predicting the exact rate path is about as important as predicting when Donald Trump will drop out of the presidential race.
Third, and more important, what might induce the FOMC to raise rates either faster or slower than 100 basis points a year? That’s where the economic forecast pops back up—and I mean the forecast for two to three years, not two weeks.
The FOMC will issue a new forecast on Dec. 16, but it probably won’t differ much from its Sept. 17 forecast, when it projected 2.3% growth in 2016, 2.2% in 2017 and 2% in 2018. At the same time, inflation was projected to track up to the Fed’s 2% target very slowly. That forecast is reasonable, but no one really knows.
Should the economy grow noticeably faster than the FOMC now believes, or should inflation rise faster, interest rates will also increase more quickly. Conversely, slower growth or a failure of the inflation rate to move up would induce the Fed to slow its rate increases. As the late Yogi Berra warned us, it’s tough to make predictions—especially about the future.
The point is that no one can predict interest rates years ahead because no one can predict the behavior of the economy years ahead. Future FOMC decisions are unpredictable, but not because they’ll be whimsical. On the contrary, policy makers will be reacting to developments in the economy in relatively systematic ways.
Despite all this uncertainty, my assessment is that the FOMC will time its “exit” approximately right.
Not because they are a bunch of geniuses. Not even because they throw more staff resources at forecasting than anyone else. But simply because they get as many bites at the apple as they need. If they err, they can speed up or slow down. And they will.
Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013).
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