From the Desk of Robert Dye

Tactical Versus Strategic Thinking at the Fed

Last Monday I wrote that the Fed still has work to do in order to set monetary policy expectations for the second half of this year. This week, various Fed officials, including FOMC Chairwoman Janet Yellen, Vice-Chairman Stanley Fischer, and regional Fed presidents Williams, Evans, Rosengren, Dudley and Bullard all made comments that at least touched on expectations for monetary policy for the remainder of this year. Their comments collectively suggest that there is an active debate within the Fed about what to do in the second half of 2017. I have argued that the Fed is close to setting an expectation for a 25 basis point rate hike at every other FOMC meeting, beginning with the December 14, 2016 rate hike. Moreover, the pattern of rate hikes would coincide with FOMC meetings that include scheduled press conferences. If they skip May 3 and hike again on June 14, as implied by the fed funds futures market, they will be on that every-other-meeting cadence. If they stick to the three rates hikes, as implied by the March 15 “dot plot,” after hiking in June, then they will have to change the cadence of rate hikes in the second half of this year.

Most of this week’s Fed commentary indicated some comfort with three rate hikes for 2017 as implied by the December 14 “dot plot.” However, there was plenty of wiggle room for more or less than two more rate hikes this year, implying a feasible range of 2 to 4 rate hikes this year.  This suggests that the Fed collectively is watching the Trump Administration very closely, in order to gauge how the economy is reacting and will react in the future to the successes and failures of the Trump policy initiatives. I think they are watching oil prices too. The recent volatility in oil prices is having an effect on inflation indicators.

In this environment, the Yellen Fed will have to remain somewhat tactical, responding to current conditions and near-term expectations, rather than driving toward the strategic goal of policy normalization regardless of near-term economic and political volatility. A tactical Fed is all about communication. Failure to communicate and set appropriate expectations for financial markets could lead to financial dislocations, with possible adverse feedback, reminiscent of former chairman Bernanke’s Taper Tantrum. This suggests that the Fed itself could add to volatility in the months ahead if they take a tactical zig, when financial markets expect them to zag. Conversely, focusing on the strategic goal of renormalizing monetary policy, while not responding to near-term issues, also poses risks if the Fed would slavishly move toward a policy goal regardless of near-term volatility. As she considers what is likely her last year at the helm of the Fed, Janet Yellen still has challenges in front of her.

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