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Why Policymakers Shrug at Market Volatility?

April 16, 2018

 

The Fed will continue to use its methodical approach on slowly increasing interest rates after the Federal Open Market Committee (FOMC) meeting in March. One statement that caught a lot of attention last week was the relatively high chance for policymakers to change the current plan for two or three hikes in the year of 2018. Even though the full picture moving forward is a bit cloudy, there are talks of a mild overshoot of the inflation target of 2% by 2020. Keep in mind that this news does not reflect the more pronounced period of above-target inflation. The bar to change the plan of increasing rates two or three times in 2018 was further supported after most of the Fed officials upgraded their opinions on global growth, expansion of the fiscal policy and the near-term outlook for the U.S. economy.

 

Even though a number of Fed officials sided on a “steeper” path for the federal funds rate, it will be important to consider whether this means two or three hikes in 2018. The majority of the participants agreed to a “more appropriate and gradual” approach on the hiking cycle. Some factors investors should be wary of are prospects for retaliatory tariffs and continuing tensions of a trade war. Fed officials appeared to shrug off the increase in equity market volatility. Some policymakers predict that it would be a better option for the Fed to raise the fed funds rate above its long-run nominal rate, while showed uncertainty around the overall policy picture and “steepness” of the curve.

 

An anonymous policymaker suggested, “a range of views on the amount of policy tightening that would likely be required over the medium term.”

 

Taking a more technical approach to this situation, the Laubach and Williams natural interest rate model suggests an estimate of the real neutral rate of 0%. This implies that a 2% neutral nominal fed funds rate is consistent with the estimate of 0%. However, investors should consider the risks and alternatives to this model. The FOMC will continue studying the gradual tightening of the monetary policy to evaluate the neutral policy rate and further assess changes in economic conditions moving forward.

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