By Paul Vigna at the Wall Street Journal
Normal is a lot harder than it looks.
The Federal Reserve on Wednesday not only refrained from raising interest rates, but it telegraphed that it would almost certainly raise rates at an even slower pace than it previously expected. This is a break from its outlook of just three months ago, when it raised its benchmark rate at the December meeting and laid out the path for the awkwardly phrased “policy normalization.”
The Fed has been talking about normalizing rates for several years now, so it’s rather jarring that just a few months after it starts doing just that, it handcuffs its own policy. Even more odd is that the data back up its original goals. All of this gives a short-term boost to the risk-on set, but it is unsettling to anybody who’s time-frame is not measured in nanoseconds.
In December, the Fed concluded that the economy was largely headed in the right direction, that the twin mandate of maximizing employment and stable prices were being met. The bank also clearly stated that it understood that policy works with a time lag, and that in order to get prices and jobs good and maximized, it needed to act then, knowing those higher rates would take some months to work their way through the system.
All that disappeared yesterday, as the Fed quickly reversed field. “It was as if a light bulb went off,” UBS’ Art Cashin wrote. The four rate hikes the Fed had been planning on for this year suddenly became two.
The practical result of all this can been seen in the U.S. dollar this morning. The dollar is down 1% against the euro and 1.2% against the yen. The WSJ Dollar Index is down 1%. “No matter where you turn, U.S. dollar charts are ‘puking,’ ” said DailyFX currency analyst Christopher Vecchio. “Most everyone was on one side of the trade, and now everyone is rushing for the exits at the same time.”
The dollar selloff started, in fact, with the first question asked of Ms. Yellen at Wednesday’s press conference. CNBC’s Steve Liesman asked if the Fed now had a credibility problem, after reversing itself so quickly. Ms. Yellen of course answered no, but the market seems to feel different. “At that point,” Dennis Gartman wrote in his daily newsletter, “the dollar was doomed. It remains ‘doomed’ thus far this morning and it may worsen we fear.”
Why does the Fed have a credibility problem? Because it has been arguing for months, years, that it is being guided by data – by U.S. data – but yesterday’s decision simply does not comport with the data. Unemployment is at 4.9%. Inflation is rising – the year-over-year “core” CPI reported on Wednesday morning came in at 2.3%. We understand that isn’t the Fed’s “preferred” gauge, but it is also not an entirely ignored gauge either. More importantly, in the three months since the Fed’s December meeting, both of these measures have further strengthened.
If you’re in the camp that thinks the odds of a recession are material if not overwhelming, then the Fed stepped back from a potentially obvious policy mistake: raising rates too soon. This is something that the Fed rather infamously did all the way back in 1937, and critics have never let them forget it. Indeed, we’ve been seeing references to 1937 for years. Here’s Bruce Bartlett writing in the New York Times on the topic in 2011. Here’s Christina Romer writing in the Economist on the topic – in 2009.
There is, however, nothing in the data that signal an imminent recession. There just isn’t. You can make all the arguments you want that point to the fallibility of the data – we do all the time – but if you’re telling the world over and over that you are “data dependent” and then you stop depending upon the data, you can see how that might confuse a few folks. What exactly is the Fed looking at now, if not the data? “The Fed’s goal is now a perfect world,” Lindsey Group’s Peter Boockvar wrote. “As we of course will never get there, the rest of us are left flying blind as to what to expect from monetary policy.”
If the data are right and the Fed is dragging its feet, that could still result in a policy mistake. Indeed, Ms. Yellen was asked if the Fed is intentionally letting inflation overshoot the target. The Fed’s credibility problem will either be amplified if the economy doesn’t behave, or vaporized if it does. The ultimate arbiter will be reality.