Bloomberg.- To err is human. To err when you’re the Federal Reserve means national wealth gets destroyed and millions of people lose their jobs.
That’s why U.S. central bankers have taken a patient approach to raising interest rates –just two hikes in the past 13 months — as unemployment declined with barely a flicker of inflation. As the Fed tightened in December and wages jumped at the end of the year, a new risk crept into their debate: What if they lift too slowly?
Turning points in the business cycle are notoriously hard to spot, and a new U.S. president promising policies to shift growth into a higher gear has introduced an upside surprise to the challenges the central bank faces. Fed officials want to run the economy a little hot to eke out labor market gains and push inflation higher. And with fiscal stimulus promised by President-elect Donald Trump potentially coming with unemployment already low, the chance increases for an error.
“There is a greater risk of a policy mistake,” said Laurence Meyer, a former Federal Reserve governor who now heads a policy analysis firm in Washington that bears his name. “The committee is going to get more than what it bargained for: They wanted a hot labor market, they wanted inflation — they are going to be tested on both.”
Since quantitative easing ended in 2014, Fed officials have indicated a preference for moving their benchmark policy rate to normal levels. Gradual is the term they’ve used to describe the rising trajectory. Now, they are trying to convince investors — and themselves — that they’re prepared to shift to faster rate hikes if necessary.
“The economy seems to be in better shape,” said Laura Rosner, senior economist at BNP Paribas in New York. While Fed officials telegraphed three hikes for this year in their median estimate released last month, there has “been no specific guidance” about the timing of those increases, Rosner noted.
Trump takes office later this month amid a pledge by his administration to accelerate growth to 3 percent to 4 percent, or roughly double the current expansion pace. Tax reforms and fiscal stimulus are two tools under discussion to boost output.
The jobless rate stood at 4.7 percent in December and wages rose 2.9 percent over the 12 months, the most since 2009. U.S. central bankers estimate the economy is at maximum use of labor resources with an unemployment rate of 4.8 percent. Market-based indicators of inflation compensation have started to move up.
The Fed’s preferred gauge of inflation, excluding food and energy, in the 12 months through November was 1.6 percent.
“If we get a positive surprise, and that could come from a number of different sources, the risk of undershooting on the unemployment rate, and over time overshooting on the inflation rate, I think, is a reasonable concern,” Boston Fed President Eric Rosengren said in an interview Monday. He expects it to reach the Fed’s 2 percent target this year.
Policy moves that look ham-handed in retrospect are fairly common in central banking. The European Central Bank raised interest rates twice in 2011 only to reverse those moves and cut further as the economy slumped into a recession the following year. Former Fed Chairman Alan Greenspan’s “measured pace” of increases between 2004 and 2006 were criticized by Stanford University Professor John Taylor as a “key factor” leading to the financial crisis.
Two catastrophic economic mistakes of the 20th century — the Great Depression and the high inflation of the 1970s — are errors of policy misjudgment no central banker wants to repeat.
Minutes from the December meeting said many participants judged that the risk of a “sizable undershooting” of their estimate for full employment might mean the committee would have to “raise the federal funds rate more quickly.”
Or maybe not. U.S. central bankers have played catch-up to the fact that for a variety of reasons the economy has been less responsive to stimulus than they expected. At the end of 2014, for example, they expected the economy the following year to expand by 2.6 percent to 3 percent. It grew 1.9 percent.
“They are constantly learning that things are slower,” said Jon Faust, a former adviser to Fed Chair Janet Yellen. “We know the direction but to know the magnitude in the current environment — we have even less confidence than usual,” he said, referring to the potential impact of future fiscal stimulus on the economy.
There are other risks, such as a crackdown on immigration and trade, both of which could also raise inflation and slow the economy.
“The Fed hasn’t had to deal with these policy risks in a long time,” said Ed Al-Hussainy, senior analyst on the global rates and currency team at Columbia Threadneedle Investments in Minneapolis. “The committee is starting to fracture in terms of how to incorporate this” into policy, he said.
Also, the dollar is up almost 6 percent percent since the Nov. 8 election according to the Bloomberg Dollar Spot Index, a trend that could slow inflation and U.S. exports if it continues.
“The Fed could overreact or underreact,” said Faust, who is now the director of the Center for Financial Economics at Johns Hopkins University in Baltimore. “This is an FOMC that went through the Great Inflation and doesn’t want to see that again. I think over-reaction is more likely.”
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