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

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Credibility is something you have to worry about with toddlers. You can’t reason with them. The best thing you can do is to consistently respond to undesirable behavior. Get this wrong and your job will be more difficult. If your interlocutor does not hide a box of Legos every time he has to count to three, for example, his child will not see that his threats are credible, and will not respond to them.

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

If the committee doesn’t care what the markets think, there isn’t much of a case to walk. Although complex in execution, the Fed has a simple job description: keep unemployment as low as possible, while keeping inflation around 2%. It can go higher than 2%, as long as inflation does not seem to be getting out of control. Unemployment is definitely low. In May it reached 4.3%, where it had not been since the beginning of this century. Evidence late last year and early this year that inflation was rising to target has since weakened. Until January of this year, both prices and market estimates of inflation – finally – showed the kind of growth you’d expect in a normal business cycle. Since then, however, that growth has slowed. Both headline and headline inflation, which includes the cost of food and energy: away slowly. Wage growth, which under low unemployment should be rising and driving inflation: gone slow. Even market measures of inflation expectations are back on the downward slope. Last September, market estimates of inflation five years from now and for the following five years both began to rise. Both reached their peak at the end of January, and now expectations, for five and even ten years into the future, are below 2%. At the end of January, there was some evidence that low unemployment was driving inflation. Early June, no.

Central banks were once less concerned about what the debt traders expected to happen to monetary policy. The bank would act, and markets would respond. Over the past twenty years, however, and especially since the financial crisis (when a lack of room for maneuver at very low interest rates forced central banks to use “forward guidance” to increase policy traction) , banks have learned how to interpret debt. markets what they will do in the future. Like children, the threat becomes as important as the response. Capital markets participants are increasingly willing to call the Fed’s bluff. Having identified or even argued the possibility of a move, they argue, the Fed must act, lest it destroy the confidence of the markets. This is more dangerous than watching; when you hear investors worried about the Fed’s credibility, you should understand that they are worried that the Fed will not credibly do what investors want the Fed to do. For about the past five years, investors have been calling on the Fed to raise rates, make the world normal again and prove that capital can provide safe returns.

When it meets next week, the FOMC will be concerned about two things. First, he must follow through on his mandate, keep unemployment low and inflation within reason. Here, there isn’t much of an argument to do anything. Secondly, however, the committee wants markets to continue to believe that they will do what they have said. Even if the Legos aren’t causing a problem at the moment, he feels the pressure to at least bring them to show he means business. But while he may hope that by doing this he will retain the ability to remove a threat to Lego in the future, his actions are not without risks. Markets, like children, could throw jokes, tantrums and break things.

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