Here’s The Big Economic Risk The Federal Reserve Is Willing To Take

world economyMy Comments: In the world of finance, especially here in the US, what the Fed does is a huge determinant of how our lives play out when it comes to our money and purchasing power. People have made and lost fortunes on their expectations of what the Fed will do next.

Here is ‘projection’ about decisions the Fed will make about interest rates, both in the next several months, and in the next few years. What I read here is that lessons have been learned from decisions made over the past few years that didn’t turn out well. But if you have a solid understanding of the variables behind Fed decisions, it will help you better understand much of the political rhetoric we’re going to have to listen to over the next few months.

If it plays out the way this writer describes it, I think it will be good for all of us.

Myles Udland Mar. 19, 2016

The Federal Reserve sent a clear message to markets on Wednesday: We’re going to run this thing hot.

Speaking at a roundtable on Thursday, BlackRock’s Rick Rieder — chief investment officer of global fixed income for the world’s largest asset manager — said the signal out of Wednesday’s meeting was crystal clear.

“There’s a takeaway [from the Fed meeting] that I think is extremely important,” Rider said Thursday.

“The Fed has made the determination that the risks of letting employment and inflation run hotter is the risk they’re willing to take.”

When economists talk about the economy “running hot” relative to the Fed’s forecasts, they’re saying the unemployment rate will fall lower and faster than expected, while prices will rise higher and faster than expected.

Said simply: The Fed is willing to let the economy get almost too good before acting to pare back any excesses.

On Wednesday, the Federal Reserve announced it would keep interest rates pegged in a range of 0.25% to 0.50%.

But the biggest development from the meeting was the Fed’s latest “dot plot” forecast of future rate hikes, which now projects there will be two additional interest-rate hikes in 2016, down from a prior call for four moves.

Based on the Fed’s latest forecasts out Wednesday, the median expectation for the unemployment rate at the end of this year is 4.7%, while “core” PCE — the Fed’s preferred inflation measure, which strips out the more volatile costs of food and gas — is forecast to hit 1.6%.

In January, “core” PCE hit 1.7%. The unemployment rate was at 4.9% as of February.

So: The Fed is (basically) there, which you’d think would argue for more not less action. And yet, they pared back their forecast.

Pantheon Macro’s Ian Shepherdson wrote Wednesday that the Fed’s statement indicated that “wishful thinking appears to have taken the place of reality-based forecasting.”

But the reason for cutting this forecast, in Rieder’s view, is that the Fed thinks an economy that is “too good” can be managed. The other side they can’t work with. (Economists call this the “balance of risks.”)

“The Fed has decided that you can let inflation run hot because you have a multitude of tools at your disposal to bring it down,” Rieder said. “It is a deflationary cycle is where the tools are very challenged.”

“Central banks around the world and monetary policy has pressed so hard to try and avoid deflation that the Fed has made a cognitive decision: Let labor run hotter. Let inflation run hotter, and we can deal with that paradigm as opposed to the other side.”

Now the view that the Fed’s move on Wednesday was decidedly dovish is not an outside one, with economists at Goldman Sachs calling this one of the most dovish announcements this century. (A dovish decision is one that suggests the Fed will keep interest rates low; a hawkish one would imply a quicker trigger on raising rates.)

Rieder also noted that Wednesday’s statement made very clear investors who are watching the Fed need to understand the Fed now has one eye trained on the US economy and one eye focused abroad.

In its statement on Wednesday, the Fed added the phrase, “… global economic and financial developments continued to pose risks.”

This, to Rieder, underscored “the extent to which external economic and financial market stresses can influence Fed policy.”

Said another way: The Fed will not stand alone.

A major theme in markets coming into this year was the apparent diverging policy paths of some of the world’s most important central banks.
The Fed appeared tilted toward tightening policy.

The European Central Bank and the Bank of Japan, meanwhile, aggressively eased policy, with both banks taking rates into negative territory and engaging in massive asset-purchase programs.

Wednesday’s statement, then, made clear that these paths won’t diverge too far.