Must-read: Ryan Avent: “No Take-Backs: The Fed Makes the Best of the Bad Situation It Created”

Must-Read: Back at the end of last October, when the Federal Reserve decided it was going to hike interest rates in December, there were three reasonably-likely outcomes for the US economy over what was then the next six months: the economy could roar ahead, and a 2015:IV rate hike followed by a 2016:I one would look prescient while a 2015:IV pause and a 2016:I double-hike would look a little behind the curve; the economy could plod along, in which one hike in either 2015:IV or 2016:I would look arguable; or the economy could dive, in which case a 2015:IV hike would look like a significant unforced error.

Now roaring ahead is off the table. The prospects now for October-April are for either a plod or a dive…

Ryan Avent: No Take-Backs: The Fed Makes the Best of the Bad Situation It Created: “SUPPOSE for a moment that you are sitting on the Federal Open Market Committee…

…You think that it was sensible to raise the fed funds target in December… [think] the second half of 2015… [shows] employers adding workers at a sustained, rapid clip… oil can’t fall that much farther… payroll growth at this pace and unemployment rate has to eventually lead to much faster wage growth and higher inflation. There’s a risk that high inflation would be hard to bring down, and we don’t want to create a new recession by hiking rates a lot in a short period of time. So best to get started with the hikes now…. So you raise rates. And… all hell breaks loose…. Market-based measures of future inflation trip on a stone and faceplant….

So then you all meet again in January…. What do you do, then? Well, you release a statement… which makes the best of December’s unforced error. And… think very hard about how to change gears in March if things continue on…. The Fed… could not simply point to the real-economy data, which don’t look that different now than they did in December, and say that its outlook hadn’t really changed…. A statement… that it remained… hawkish… would force… to a nasty market panic. And enough panic can become self-fulfilling.

The statement therefore needed to… demonstrate that: the Fed’s view is basically unchanged, but the Fed is also aware of potential trouble brewing and stands ready to act accordingly, but the brewing trouble isn’t the sort of thing that should cause anyone to worry…. The problem is that now the Fed doesn’t meet again until March…. If it chooses to wait while markets do their thing, a March policy reversal could come too late to prevent a sharp deceleration in American economic activity….

It is possible that America’s recovery will roar ahead, and the Fed will be able to hike four times in 2016. But the Fed is now in a very uncomfortable position, which could easily become much more uncomfortable still. That was always the risk in hiking before economic conditions really demanded it. When both interest rates and inflation are very low, there is unlimited room to increase rates in response to an unexpected (and improbable) surge in inflation to a rate well above the target. On the other hand, under those circumstances it is very hard to react in time and with adequate force to an unexpectedly weak economic performance…

January 28, 2016


Brad DeLong
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