By Charles H. Green
According to economist Kevin Kliesen, there’s a high likelihood that the Federal Reserve will begin its interest rate normalization process sometime in 2015, but to be certain, that decision will ultimately depend on the data and resulting economic forecasts. As a means of trying to understand what to expect, he suggested reviewing previous tightening cycles employed by the Fed may reveal evidence about what effects lie ahead.
Kliesen is Business Economist and Research Officer at the Federal Reserve Bank of St. Louis, and spoke before an audience gathered for the second quarter economic forecast presented by the Robinson College of Business at Georgia State University recently.
It’s widely known that the Fed removed the word ‘patience’ in it’s March statement concluding the FOMC meeting, which had been used at end of QE3 program as an expression of the pace they expected to proceed. However in March, Fed Chair Janet Yellen remarked that conditions “may warrant an increase in the fed funds rate target sometime this year.”
Historically the Fed’s decision to raise rates has always been more difficult than lowering rates and is always debated intensively. Former Fed Chair Arthur Burns described it as the anguish of the central banking, how raising rates evoked violent criticism. Yet more often, the Feds are accused of favoring the financial markets at the expense of the public and savers.
The Fed’s debate usually plays out through speeches offering various viewpoints of the twelve district presidents, all of which are monitored intensely. In their April survey, the majority (74%) of Blue Chip forecasters expected a rate increase in September, a major revision from the January survey when 65% believed that rates would rise in June.
Why all the uncertainty? It seems as though the data is not cooperating. As more data is collected, any decision to raise the Fed funds rate seems to be pushed farther out, indicating that both the Fed’s and private forecasts have been too optimistic. Inflation has continued to be much weaker than expected. But recall Chair Yellen’s remark earlier this year: “Don’t wait for the 2% inflation target.”
History suggests that monetary policy makers have stayed ‘too easy’ too long in the past. With as many economic factors affected by monetary policy–such as spending on interest-sensitive goods, bank lending, corporate balance sheets, household net worth and asset prices,–it’s easy to understand how the macro economy can be heating up faster than traditional economic factors can track.
In previous cycles, rate tightening always exceeded the market’s expectations, particularly during 2004-2006 (+4.25%), which carries its own risks and exposure. Normally, credit risk spreads and stock prices fall early in the cycle, with risk spreads rising later. But it takes about a year for industrial production and consumer spending to fall off. And in three of the four last cycles, it took about a year for the Treasury rate yield curve to to invert.
Net effect: the year following liftoff of the normalization, the economy generally improves, followed by slower growth later.
And it’s worth noting that Kliesen related that “history suggests that long expansions with low inflation tend to have smaller increases in the Fed’s policy rate, so keeping inflation low and stable is key. But history also suggests that each tightening cycle depends significantly on underlying economic conditions, and oil shocks have been important in the past.”
What do you think? Comment on this page or write me at Director@SBFI.org.