Federal Reserve Unsure on Path Forward

on Jul 13, 2016

The Federal Reserve is running into a major problem, and it is unsure on how to approach future interest rate increases, as revealed by its most recent minutes. The global economy is in disarray, and the Fed recognizes the perils of raising US interest rates while the rest of the world struggles with its problems.

For years now, officials at the central bank have repeated the same mantra: employment and inflation are the two most important metrics that we watch. One of the central bank’s governors said as much earlier in the week. Daniel Tarullo said the Fed should hold off on raising interest rates, despite the dire need for an increase, until inflation rises. Across the developed world, inflation has remained far below target, and the US is no exception. Currently, the Fed targets a 2 percent inflation rate, but the US has remained consistently below that. However, recent data has shown inflation ticking up to an annual 1.6 percent in the last months.

However, that may not be convicting enough for some officials at the Fed. As Tarullo explained, the central bank does not have all the tools necessarily to spark growth and prevent a slowdown. One misstep by the Fed and markets may have to deal with an additional problem. If both consumers and businesses retract their spending, the Fed can say goodbye to its inflation hopes. Tarullo instead stated that there is a need to put more of an emphasis on employment, which the central bank has more control over. He argued that the Fed cannot cannot afford to wait around for inflation to increase and instead it should realize the benefits of a strong labor market.
However, Tarullo’s arguments may already be heeded by others at the Fed. It now appears that there is a clash of opinions among Fed members. Although the US labor market has performed incredibly well over the past year, especially considering the waning global economy, recent data from May showed significantly less job growth than was expected. Both analysts and Fed officials disagree on the meaning of these figures. Some argue that the data is a mere outlier and that job gains will pick back up sometime soon, while others argue that weak job growth will be a precursor for more economic trouble in the future.
Another critical issue for the central bank is the financial shock. Since the subprime mortgage crisis, the Fed has taken major initiatives to prevent systemic collapse and limit financial companies’ exposure to market panics. The bank recognizes that its actions have far reaching consequences. Considering the role that the United States plays in the world’s economy, a decision to raise interest rates too soon could send shockwaves through an already weakened globally economy. With the panic of the Brexit and the Italian banking crisis, combined with rising bad debts and weak growth everywhere, a decision to raise rates could spell disaster.
One point that all members of the Fed agree on is that interest rates cannot remain low for too long. The low interest rate environment is leading to various bubbles across the economy, as some analysts believe. This is particularly true for the bond market. With the fallout of the Brexit, global bond yields fell to record lows. Low interest rates have allowed cheap credit to flow, which adds to the trend of falling bond yields. Now Fed officials are concerned about income and corporate profit growth in the US. The decision to raise interest rates appears to focus on one particular metric: the performance of the US economy compared to other major regions of the world. Willian Dudley, the President of the New York Fed, noted that the falling yield on US Treasury notes hinted that investors are concerned about US growth. However, Stanley Fischer, Vice Chairman of the Fed, noted himself that the US economy has performed far above its global counterparts in most sectors of the economy. The decision to raise interest rates clearly revolves around sentiment across the entire global economy, not just the performance of the US.

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