Does anyone else find it a bit concerning the way the Federal Reserve communicated its plans to raise interest rates in March, and that perhaps it has changed the criteria for how it will make interest rate decisions going forward?
To use a playground analogy, it almost seems like the Federal Reserve got tired of the financial markets refusing to believe its guidance for interest rates and decided to teach the “bully” a lesson. Since the Federal Reserve began publishing its “dot plots” – in an effort to give the financial markets forward guidance – the financial markets have refused to believe the guidance and forecasted a far slower pace of interest rate increases. Unfortunately for the Federal Reserve, the financial market forecasts were consistently closer to what the Federal Reserve actually did. That all changed approximately two weeks after the Federal Reserve’s February meeting and a month in advance of its March 15th meeting. At that time Federal Reserve officials appeared to resolve to have a united front and began to aggressively deliver the message that economic conditions had improved sufficiently to warrant raising rates at the March 15th meeting. That caught most economists and financial market participants by surprise and forced them to change their forecasts to come in line with the Federal Reserve’s message.
After the March 15th meeting, the Federal Reserve announced that they were raising the federal funds rate by .25% but remained data dependent for future interest rate decisions. Perhaps the one dissenting voter at the meeting (Minnesota Federal Reserve President Neel Kashkari) stated the market participants’ sentiment the best: in an interview with Bloomberg, Federal Reserve president Kashkari said, “The economic data is basically moving sideways, so I’m asking, what’s the rush to raise rates?”
Has the actual economic data improved from the February meeting? Not really.
Are we approaching full employment as many of the Federal Reserve officials have been suggesting in their speeches? There is still active debate over that question. It truly depends on who you ask and what data you look at.
Did inflation suddenly become a problem?
So what has changed that may have caused the Federal Reserve to raise rates in March after leaving them unchanged in February?
These areas of improvement are what I would classify as “soft” economic data. They indicate that consumers and businesses may be poised to increase spending. Confidence and sentiment now need to be converted into concrete action. That means that the following metrics need to improve going forward:
Is the Federal Reserve changing its criteria from being economic data dependent to relying on financial market indicators and confidence/sentiment levels as the new guiding criteria for interest rate decisions? Are anticipated results versus actual results the new criteria that the Federal Reserve is using? Its action in March gives the appearance that it is now willing to raise rates in anticipation of improved economic strength rather than waiting to see confirming evidence. Even though during her press conference Chairman Yellen stated that the Federal Reserve remains data dependent and will still move cautiously, its action in March indicates we should watch closely to see if its criteria has changed. If this is true, this could be a policy error on the Federal Reserve’s part. The error is not in the actual action of raising rates. In reality, raising interest rates is simply removing the artificially low rates that were used to try and replace a lack of fiscal policy and bring them back to more normal levels. This process will help to bring the cost/benefit closer to being in balance between savers and borrowers. The policy error could be that it puts the Federal Reserve’s credibility at risk.
If the consumer does not follow through with more real spending and businesses don’t follow through with increased investment, then the Federal Reserve may once again have to back off and limit or stop raising rates. If the Federal Reserve loses credibility, then forward guidance loses its value as a feather in the quiver of Federal Reserve policy tools.
The views or opinions in this article are those of the author and do not necessarily represent the views of Washington Trust Bank or senior management. Washington Trust Bank believes that the information used in this blog was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinions expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Steve Scranton is the Chief Investment Officer and Economist for Washington Trust Bank and is a CFA charter holder with over 30 years of investment experience with equities, tax-exempt and taxable fixed income securities. Steve actively participates on committees within the bank to help design strategies and policies related to client and bank owned investments. Steve also serves as the economist for the Bank and has been a featured speaker for both client and professional organization events throughout the Northwest.