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Why the Fed is likely to raise rates, despite low inflation

Summary:
CREDIBILITY is a thing you have to worry about with toddlers. You cannot reason with them. The best you can hope to do is respond consistently to undesirable behaviour. Get this wrong and your work becomes harder. If your correspondent doesn’t actually go and hide the box of Legos every time he has to count to three, for example, his child will not find his threats to be credible, and will fail to respond to them. This is the problem the Federal Reserve has now with financial markets. For six months the Federal Open Market Committee (FOMC) has been carefully managing its speeches, meeting minutes and economic projections to one end: convince debt markets that it will raise the benchmark interest rate by a quarter of a percentage point at its June meeting. It has succeeded. FedWatch, a tool

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CREDIBILITY is a thing you have to worry about with toddlers. You cannot reason with them. The best you can hope to do is respond consistently to undesirable behaviour. Get this wrong and your work becomes harder. If your correspondent doesn’t actually go and hide the box of Legos every time he has to count to three, for example, his child will not find his threats to be credible, and will fail to respond to them. 

This is the problem the Federal Reserve has now with financial markets. For six months the Federal Open Market Committee (FOMC) has been carefully managing its speeches, meeting minutes and economic projections to one end: convince debt markets that it will raise the benchmark interest rate by a quarter of a percentage point at its June meeting. It has succeeded. FedWatch, a tool that estimates how markets think monetary policy will go, pegs the probability of a June rate hike at 91%. This leaves the committee with a familiar problem. Having told the market what it’s going to do with the Legos, does it now have to do just that, even if it’s a bad idea?

If the committee doesn’t care what markets think, there’s not much of a case for hiking. Though complex in execution, the Fed has a simple job description: keep unemployment as low as possible, while keeping inflation around 2%. It can go above 2%, so long as it doesn’t look like inflation is getting out of control. Unemployment is certainly low. In May it reached 4.3%, where it hadn’t been since the beginning of this century. Evidence late last year and early this year that inflation was creeping up to target has since weakened. Until January of this year, both prices and market estimates of inflation showed—finally—the kind of growth you’d expect in a normal business cycle. Since then, however, that growth has gone slack. Both core inflation and headline, which includes the cost of food and energy: gone slack. Wage growth, which under low unemployment should be rising and driving inflation: gone slack. Even market measures of inflation expectations are back on the downslope. In September of last year, market estimates of inflation five years from now and for the five years after that both began to rise. Both reached a peak at the end of January, and now expectations, for five and even ten years in the future, are below 2%. In late January, there was some evidence that low unemployment was causing inflation. In early June, there isn’t. 

Central banks were once less concerned about what the people who trade debt expected to happen to monetary policy. The bank would act, and markets would respond. Over the last twenty years, however, and particularly since the financial crisis (when the lack of room for manouevre at very low interest rates led central banks to use "forward guidance" to increase policy traction), banks have learned how to explain to debt markets what they will do in the future. As with toddlers, the threat becomes as important as the response. Participants in capital markets are increasingly willing to call the Fed's bluff. Having signalled or even mooted the possibility of a move, they argue, the Fed must act, lest it squander the trust of the markets. This is more of a threat than an observation; when you hear investors worry about Fed credibility, you should understand that they are worried the Fed will fail to credibly do what investors want the Fed to do. For about the last five years, investors have wanted the Fed to raise rates, make the world normal again and confirm that capital can provide safe returns. 

When it meets next week, the FOMC will be concerned about two things. First, it must follow its mandate, keeping unemployment low and inflation within reason. Here, there is not much of an argument to do anything. Second, however, the committee wants markets to continue to believe that it will do what it has said. Even though the Legos are not causing a problem just now, it feels pressure to take them anyway to show it means business. Yet while it may hope that in doing so it will preserve the ability to threaten Lego removal in the future, its actions are not without risks. Markets, like toddlers, could fuss, throw tantrums and break things.

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