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Fed Stability Challenged by Growing Crosswinds

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federal_reserve_bankThe Federal Reserve will meet next week amid mounting pressures from a number of directions. Under the circumstances, a decision to do nothing about interest rates at this time seems the most likely outcome - but that would be less of a cop-out than it might seem.

The Fed's mission is basically to walk a tightrope. It needs to keep the federal funds rate low enough to foster economic growth but high enough to discourage inflation from climbing past a moderate level. The April 30/May 1 Federal Open Market Committee (FOMC) meeting comes at a time when maintaining that balance is complicated by signs of slowing economic growth and rising inflation, with political pressure thrown into the mix as a wild card.

Slower economic growth - roadblock to higher federal funds rate

Last year, amid an environment of generally encouraging economic growth, the Fed made a series of four interest-rate hikes, an increase of 1 percent overall. It sought to use the favorable economic environment as an opportunity to return the fed funds rate to a more normal level. Based on the FOMC's year-end projections, it appeared the group expected a couple more rate increases to occur in 2019.

The Fed's policy of rate normalization is designed to provide more latitude for interest-rate reductions the next time economic growth starts to deteriorate. Unfortunately, growth began to slow in the second half of 2018. The initial estimate of first quarter 2019 growth is due to come out on April 26, just days before the next Fed meeting. It may well show a third consecutive quarter of slowing growth.

Already, the Fed has lowered its year-end projections by half a percent, indicating a likelihood of no rate increases this year. If economic growth slips into negative territory, the Fed will have to strongly consider lowering those projections even further - and the possibility of lowering the fed funds rate too.

Rising inflation - roadblock to lower federal funds rate

Complicating the response to slowing growth are hints of rising inflation. After the Consumer Price Index (CPI) was essentially flat in November, December and January, it perked up to 0.2 percent in February and then 0.4 percent in March. While 0.4 percent may not sound like much, it projects to a 4.8 percent annual rate of inflation - more than double the FOMC's 2 percent target.

Month-to-month inflation numbers tend to be erratic, but what may be more ominous than recent CPI numbers is that a driving force behind them is rising petroleum prices. The price of crude oil is up 41 percent this year, and the average retail gasoline price is up 24.1 percent. Higher oil and gasoline prices have a way of spilling over and affecting other prices. This inflationary pressure will make it harder for the Fed to respond to slowing growth by lowering rates.

Can political pressure compromise Fed independence?

As if slowing growth and rising inflation weren't difficult enough issues with which to contend, the specter of political pressure on the Fed has been raised recently too. At first, this was manifested in public remarks, but recent nominations of two candidates to the Fed's Board of Governors (whose backgrounds are considered more political than economic) have made the pressure more tangible.

The reason central bank independence is highly valued is that, historically, politicians in power have had an impulse to lower interest rates leading up to elections in order to spur economic growth. Under the wrong economic circumstances, this type of political expediency can have the side-effect of unleashing years of inflation, as happened in the United States in the 1970s.

Fortunately, the FOMC is made up of seven members of the Fed's Board of Governors (there are currently two vacancies, hence the recent nominations) and four presidents of regional Federal Reserve Banks. There has been a fair amount of consensus among the current members of the FOMC, so a couple new members shouldn't throw the Fed's interest-rate policy too far off course. However, if the perception of eroding FOMC independence continues to grow, the Fed will have less credibility with the financial markets and the business community when it comes to future policy directions.

What to expect from this Fed meeting

In its last meeting, the FOMC's updated projection of where the federal funds rate would be at the end of the year indicated an expectation of no Fed-interest-rate increases this year. However, given the conflicting and still-inconclusive signals about economic growth and inflation, no departure from that course is clearly indicated yet.

Thus a change in the Fed interest rate at this time would have to be viewed through a political lens, which would have troubling implications for the Fed's future. Most likely, the Fed will show it has enough independence to maintain a steady hand through these economic and political crosswinds.


More resources for journalists and consumers:

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The Truth About Investment Risk

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