What now for the Federal Reserve?

"On the face of it, a strong growth, low inflation environment is what all central banks aspire to achieve, but the fact interest rates remain so low is causing some unease at the Federal Reserve," ING economists argue.

Key quotes

Outgoing Fed Chair Janet Yellen warned last September that “persistently easy monetary policy might lead to increased leverage and other developments, with adverse implications for financial stability”.

Fed officials have also suggested that the extreme length of the current economic cycle means the US may not be that far away from the next downturn. Given interest rates are so low and the Fed’s balance sheet remains huge the US has less ammunition to stimulate the economy relative to previous cycles.

This clearly hints at a desire to see higher interest rates in the US and helps explain why Janet Yellen has repeatedly warned of being “wary” of raising interest rates “too gradually”. Even though she is leaving the Federal Reserve next month, the Fed’s dot diagram clearly signals an appetite amongst the membership to raise rates three times this year. This suggests her cautiously hawkish stance is widely shared. Admittedly there is very vocal dissent from a small minority, most notably Neel Kashkari and Charles Evans, but neither will be voting at this year’s FOMC meetings.

With inflation likely to push gradually higher the Federal Reserve is set to respond. However, the imminent changes at the top of the FOMC could result in a pause in the first quarter as Jay Powell finds his feet. There's also some uncertainty as to how the recent bad weather has impacted the economy. With core inflation set to remain below 2% in the current quarter, the Fed may choose to “wait and see” despite the market currently pricing a 75% chance of a hike by the end of March.

However, we do expect interest rate rises in the second, third and fourth quarters. The Fed’s emphasis on financial stability risks from loose monetary policy and the fact financial conditions remain loose (flat yield curve and weaker dollar) means we see the risks skewed towards more, not fewer, rate rises.

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