Will The Expected Faster Fed Rate Increases Drive the U.S. Economy into a Recession?

US monetary policy appears to be transitioning from “very gradual” to “gradual” normalization. After raising the Federal Funds Rate (FFR) twice with a gap of one year between the two increases – one in December 2015 and another in December 2016 – the Fed appears to be comfortable to raise the FFR a bit faster by possibly again telegraphing about 3 increases in 2017 after doing the same in 2016. In 2016 the Fed did not follow up on its signal of 3 increases and it may not also in 2017. Annual growth in 2016 is at 1.6% which is about 1% less than annual growth in 2015 and annual growth forecasts based on the Quarter 1, 2017 numbers indicate that growth in 2017 could be similar to 2016.

Discussion about U.S. growth data, however, is missing from the current debate about whether the Fed will raise the FFR by 25 basis points to between 0.75 and 1 percent on March 15. The markets have priced-in the rate increase looking at the recent pronouncements by senior Fed officials, inflation, and labor market data, and the rate increase seems to be a certainty with the markets wholly concurring with the Fed that the rates should go up. In fact, if the Fed delivers a surprise on March 15 by not raising the FFR, financial markets could fall fearing that the Fed signaled a lack of confidence in the US economy.

Fed’s confidence in the economy and its view that the economic environment in the rest of the world is also improving – diminishing foreign risks to the US economy and also lower risks to global economic growth – should, the Fed appears to expect, keep US growth on a solid footing. Such a rhetorical expectation appears to be grounded in data because US growth in the most recent two quarters – Q4 2016 and Q1 2017 – points to an annual growth rate in both 2016 and 2017 that is close to the potential growth rate of between 1.4% and 1.7% according to estimates by the Congressional Budget Office (CBO) suggesting that there are no risks yet to inflation from growth unless it is above 1.7%.

An important point of discussion for the rate setting Federal Open Market Committee (FOMC) of the Federal Reserve would be the natural or neutral rate of money supply: is the FFR below, at or above the natural rate of interest? If the FFR is neutral, then inflation must be stable and growth must be at the trend rate. This may already be the case. Growth is at potential and inflation – by the Fed’s preferred measure of rise in core personal consumption expenditures (PCE) – should be hovering around 2%. With core PCE currently around 1.7% there is no impending risk to the Fed’s inflation target.

Considering that annual growth has fallen by 1% in 2016 when compared to 2015, and 2017 growth rate could be the same as that of 2016, the behavior of growth in 2016 and 2017 shows counter-intuitively that, given the economic structure, the FFR is perhaps already at the neutral rate and that any higher FFR will suppress growth. It may fall to fiscal policy to identify new growth drivers to push up both the potential growth rate and the natural rate of interest. The financial markets are thus, quite appropriately, reacting positively to promises by the new US administration of fiscal expansion.

A commitment by the Fed to accelerate the pace of interest rate increases should also take into consideration growth data and not merely inflation and labor market statistics if the Fed is to avert the risk of driving the economy into a recession with faster rate increases.

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