After first rate hike, Fed faces challenge

Washington (Dec 27)  When expansions end and the economy tips into recession, one or the other is usually to blame.

In the past, the culprit has frequently been fire — an overheating economy and rising inflation —> > > > that prompted the central bank to push up interest rates until they ultimately choked off growth.

Ice is more unusual, at least in the United States, but it is often more painful, as excess capacity, weak demand and falling prices foster a deflationary slump that can prove difficult to escape.

As the Federal Reserve embarks on a new chapter in monetary policy, having raised rates on Dec. 16 for the first time in nearly a decade, policymakers are acutely aware of the risks posed by both possibilities.

“Raising rates the first time may have been the easy part. Now comes the challenging part,” said Mike Ryan, chief investment strategist for UBS Wealth Management Americas.

Fed officials do not have to look far for real-world examples of what can go wrong.

European central bankers raised rates twice in 2011, killing off a nascent recovery and plunging the eurozone into a double-dip recession that it is still struggling to overcome.

But being too slow to tighten the reins of monetary policy can prove perilous, too.

A series of steady quarter-point rate increases by the Fed between 2004 and 2006 seemed prudent at the time, but in hindsight the central bank has been blamed for moving too slowly, failing to head off the economic catastrophe that followed the implosion of the housing bubble in 2007.

The biggest problem is that higher interest rates do not bite in predictable ways. Not only do they take time to percolate through the real economy, but there is also a difficult-to-foresee threshold, at which point the impact can suddenly shift from mild to severe.

“I’m sure there is a tipping point,” Ryan said. “It’s just hard to know in advance precisely where that is.”

At least for now, though, few analysts expect the Fed’s initial moves to bring the nation’s 61/2-year-old expansion to an abrupt end.

“The rate hike this month and those next year may not really be felt until 2017,” said Michael Hanson, senior U.S. economist at Bank of America Merrill Lynch. “Evidence from past cycles suggests it could take a year, rather than the next quarter or two.”

The Fed’s task this time is even more complicated because other central banks are leaning in the opposite direction.

With growth in Europe still sputtering, the European Central Bank has belatedly turned to the tools embraced by the Fed several years ago, buying up securities and pumping money into the financial system. But even with some interest rates there in negative territory, Mario Draghi, president of the ECB, is under pressure to loosen monetary policy further.

In Asia, the People’s Bank of China is also in easing mode, as officials try to cushion what looks like an increasingly hard landing for the economy there, the world’s second-largest. Similarly, Japan’s central bank is keeping interest rates at rock-bottom levels to encourage growth.

The combination of lower rates abroad and rising ones at home is making the U.S. dollar surge against other currencies. While that might be good for U.S. tourists heading overseas, it hurts manufacturers in the United States seeking export markets and makes imported goods more competitive, undermining the country’s trade balance.

For now, most economists say the danger of too little inflation outweighs the risk of too much: Ice, in effect, may be more of a worry than fire.

“The risk is skewed toward moving too fast,” said Michael Gapen, chief U.S. economist at Barclays. “That’s especially true as the strong dollar and lower-priced imports keep inflationary pressures at bay in the United States.”

In its statement on Wednesday about the decision to raise rates, the Fed noted there had been a “ shortfall” in terms of actual inflation’s not measuring up to the central bank’s 2 percent goal, which it considers helpful in supporting a more robust economy.

Scott Anderson, chief economist at Bank of the West in San Francisco, believes the reference to stubbornly low inflation is significant.

“This is new language,” he said. “The doves on monetary policy are saying they will go along with the rate hike now, but want to see some acknowledgment that low inflation is still a concern.”& amp; amp; lt; /p>

For his part, Anderson expects the economy to continue to grow at a moderate annual pace of about 2.4 percent in 2016. If that forecast for growth is correct, he predicts the Fed will raise rates three times next year, lifting the benchmark rate to a range of 1 to 1.25 percent by the end of 2016.

“Consumers are cautious, but they still have the capacity to spend,” Anderson added. “Jobs and incomes are growing, debt levels are low, and gas at about $2 a gallon should help. When people realize the sky isn’t falling because the Fed is raising rates, they will go back to their usual spending habits and save the day.”

A growth rate of about 2 percent would be in line with the steady, but disappointing, advance that has characterized the current recession since it began in mid-2009. By contrast, the economy grew by 3.8 percent in 2004 when the last tightening cycle began, and by 4 percent in 1994 when an earlier round of rate hikes got underway.

The comparatively weak recovery, which has left most Americans struggling to maintain their standard of living, is the principal reason the Fed has promised to move more slowly during this tightening cycle than in past ones.

In the mid-2000s, the Fed raised rates by 0.25 percentage point at every meeting between June 2004 and June 2006, 17 straight increases that lifted rates by more than 4 full percentage points over two years.

The tightening campaign in the 1990s was even steeper, as rates moved up 3 points in one year. Although that wreaked havoc on the stock and bond markets in 1994, the move might have helped slow growth to a sustainable pace and set the stage for the 1990s expansion to extend for a full decade.

Many analysts say that the current expansion could display that kind of longevity.

“Expansions don’t die of old age,” said Ryan, of UBS, echoing comments by the Fed chairwoman, Janet Yellen, at her news conference on Wednesday. “They die from exhausted demand, but consumers aren’t exhausted.

“And the backdrop of low inflation won’t force the Fed into an aggressive stance,” he predicted. “This expansion can go on for a while.”

Source: TheColumbusDispatch