The More Things Change, the More They Stay the Same
The federal funds rate target has not budged since the Federal Open Market Committee set it at 5¼ percent in June 2006. The Committee’s statement announcing this action noted that economic growth was likely moderating from its strong pace earlier that year, partly because housing markets were cooling. The statement also pointed out that measures of core inflation had been elevated for some months and that, although inflation expectations had been well-contained, high levels of resource utilization and of prices for energy and other commodities could sustain inflation pressures.
At the time, judging that some inflation risks remained, the Committee cautioned that some further policy firming might be needed, but that the extent and timing of any actions would depend on incoming evidence about the outlook for inflation and economic growth. In financial markets, there were considerable differences of opinion about whether the next rate movement would be up or down. Now, nearly a year later, the Committee has yet to adjust the funds rate target one way or the other.
The uncertainty about the policy outlook last June grew primarily from uncertainty about the outlook for inflation and economic growth, the factors that the Committee said would shape their decisions. At the time, analysts’ prevailing opinion was that the housing sector would suffer a mild downturn through the end of the year. However, their assessment deteriorated as the year progressed, and their growing expectation that policy would ease was reflected in the federal funds futures market. However, by early this year, many analysts thought they saw signs of stabilization, perhaps even of a turnaround, in the housing sector. So, since the rest of the economy seemed to be holding up well, market expectations of a funds rate reduction began to return—though not all the way—to the view that the rate would continue unchanged.
The inflation outlook has been equally difficult to discern. On one hand, the Committee’s June 2006 statement explained that the cumulative effect of previous interest rate increases could be expected to slow, even to reverse, inflation’s upward momentum. On the other hand, the Committee noted that resource utilization remained high and that energy and commodity prices might still pose inflation risks.
Although financial market participants generally interpreted the Committee’s statement as an announcement of a “pause,” it seems fair to say that few analysts expected the pause to last quite this long. Interestingly, the reasons for the pause have changed over time, as incoming data caused the perception of risk to shuttle between economic growth and inflation.
The Committee’s “wait and see” posture proved very durable in an environment that produced somewhat weaker growth—but also more inflation—than anticipated. For their part, most financial market participants now expect the economic outlook to evolve in such a way that the Committee will gradually lower the federal funds rate target by 50 to 100 basis points beginning later this year. But analysts’ reactions to incoming data, the Committee’s press statements, and speeches by Federal Reserve officials suggest that although the FOMC may still be “learning to talk,” market participants understand fairly well what the Committee intends to accomplish and how it views the complex workings of the global economy.
I remember a time, not so long ago, when monetary policymakers—and many academics too—thought policy worked best when it caught markets by surprise. Today, exactly the opposite opinion prevails: Financial markets should be able to predict what policymakers will do, even when circumstances change. At the moment, the Committee and the financial markets seem to understand one another well. That understanding is certain to be tested, however , either when the Committee plans to move before the markets expect it to or when the markets tell the Committee to move before it recognizes the need to do so. History provides examples of each.