WASHINGTON • The Federal Reserve's official mission is to take care of the US economy, and the economy is doing pretty well. The unemployment rate is 4.7 per cent, its lowest in nine years, wages are rising steadily and, after a soft first quarter, economic growth is accelerating.
For Fed chair Janet Yellen, it all points to a recipe for higher inflation, a single month of weak jobs data notwithstanding. Some of her colleagues would also emphasise that keeping rates too low could create imbalances in the economy and spur new financial crises.
But global financial markets aren't having it. If you take bond and currency markets at face value, the underlying path of growth in the US is too weak and global deflationary forces too powerful; the Fed will need to raise interest rates much slower than its officials say they expect.
If markets could talk, they would be saying: "We don't think you'll raise interest rates as much as you say, and if you do it anyway, you'll probably regret it."
All 17 top officials of the Fed expect an interest rate increase this year. Yet financial futures markets price in only about a 40 per cent chance that it will happen. Fed officials envision a 2.4 per cent interest rate target at the end of 2018, versus 0.6 per cent that is priced into the markets. Fed officials see inflation rising to its target of 2 per cent by 2018 and staying there; the price of inflation-protected bonds implies it will be much lower.
There are technical factors that distort those market signals, as Dr Yellen noted at her news conference. For example, aggressive bond-buying by the European Central Bank and the Bank of Japan may be sending money flooding across borders into higher-yielding US bonds, making US rates lower than the economic fundamentals would justify. But even with those distortions, Dr Yellen and the Fed face danger if they ignore these market signals entirely.
A pattern has repeated for years: Markets expect slower growth, lower inflation and a slower path of rate increases than Fed officials themselves; markets turn out to be right.
Two years ago, for example, the median projection among Fed officials was that its interest rate target would be 2.5 per cent at the end of 2016. A year ago, it was 1.68 per cent at the end of 2016. Now both look like pipe-dreams. Fed leaders expect a 0.9 per cent rate at the end of the year, and markets expect 0.4 per cent.
Dr Yellen and the Fed have been grappling with which set of signals to listen to, and the tone that pervaded on Wednesday was one of uncertainty. "We're quite uncertain about where rates are heading in the longer term," she said. "Many of us believe as a base case it's reasonable to assume those rates will move up over time, but we aren't certain about that. There could be revisions in either direction."
Ultimately, by holding off on a June rate increase and marking down rate forecasts for the months ahead, the Fed nudged its views towards market views.
As Fed officials make their decisions at their remaining four meetings of the year, the issue that hangs over them is as complex as ever. It is not merely about evaluating how the US economy is doing and whether it remains solidly on track.
Fed officials must also weigh whether the global force of low inflation is so powerful as to continue dragging down prices in the United States even after the domestic economy has healed. They have to figure out whether the feedback loops between economic weakness and easy money in other countries create unconventional risks to the US by raising rates too quickly.
The 2008 financial crisis was a profound test of the Fed's ability to prevent economic collapse; from 2009 to 2012, the central bank made crucial decisions to keep pushing the US economy towards recovery. This year is showing just how intricate the exit from this era of easy money will truly be.
NEW YORK TIMES