Global financial markets may have just grounded the hawks at the U.S. Federal Reserve.
Bill Dudley, the president of the Federal Reserve Bank of New York, signaled Tuesday the American central bank is seriously pondering whether financial-market volatility from China to the U.S., low oil prices and the stronger dollar warrant keeping interest rates at historic lows for longer than it had anticipated as recently as December.
Dudley, who sits on the Fed’s powerful rate-setting body, used the occasion of a speech in China to outline how international developments may be wrenching the Fed, which expected moving toward higher interest rates in 2016, slowly off course. Charged with maximizing U.S. growth and limiting inflation, the Fed is facing new pressures on both fronts, Dudley said.
“At this moment, I judge that the balance of risks to my growth and inflation outlooks may be starting to tilt slightly to the downside,” Dudley said in his prepared remarks.
The statements are bound to intensify speculation that the Fed will give a bolder policy signal about its intentions at its March meeting. It nodded toward global developments at its January meeting without hinting at revised thinking, and has stressed that it will react as incoming economic data warrant. Most forecasters have already abandoned predictions the Fed will hike rates in March.
Dudley’s statements echo the warnings that Lael Brainerd, a governor of the Federal Reserve Board in Washington, has made recently about how global developments such as the declining oil prices, strengthening U.S. currency and volatile financial markets tend to push central banks in the same direction: that is, to either keep rates low or take them into negative territory. “Predictions that U.S. monetary policy would chart a notably divergent path have been tempered by powerful crosscurrents from abroad,” she said in a speech Feb. 26.
The dollar has edged higher since markets began anticipating increased U.S. interest rates last year, and even after the Fed raised its benchmark rate by 0.25 percentage points in December. Higher rates tend to strengthen the dollar, since they push up the value of dollar-denominated investments such as corporate and government bonds, but they can also chip away at exports, which become more expensive relative to those of other countries.
A key pillar of the argument for more Fed rate rises has been that the central bank tends not to react forcefully to financial-market turbulence unless there’s a threat it would spread rapidly and pose a systemic threat, as was the case in 2008.
Goldman Sachs economists David Mericle and Daan Struyven analyzed the Fed’s response to episodes of financial chaos found that only two events — the collapse of a major hedge fund in 1998 and the eurozone crisis — had that effect. With an eye on plunging stock markets early this year, they wrote that “the Fed’s policy response would likely depend mostly on the potential for financial contagion, which seems less likely now.”
In Dudley’s speech, he took implicit exception to this argument, saying he had already marked down his growth prospects for the U.S. economy “very modestly” and could do so again. “If this tightening of financial conditions were to persist, it could potentially lead to a more significant downgrade to my outlook,” Dudley said.
More seriously, Dudley highlighted how the Fed’s yearslong battle to ensure that low inflation does not flip over into outright deflation — poisonous for a modern economy — might be winnable, but is not yet won.
He pointed out that even if the U.S. consumer price index, which is based on a hypothetical basket of goods and services that households buy, edges above the Fed’s goal of 2 percent, other signs are less encouraging. For example, measures of actual purchases by U.S. consumers and surveys of inflation expectations remain stuck below the Fed’s target.
And low oil prices have the potential to feed those expectations.
“Further declines in either measure would be worrisome,” Dudley said. “These developments merit close scrutiny, as past experience shows that it is difficult to push inflation back up to the central bank’s objective if inflation expectations fall meaningfully below that objective.”