What market turbulence means for Fed rate hikes

February 8, 2018 | Last updated on February 8, 2018
5 min read

Wall Street has thrown a rather sour welcoming party for Jerome Powell.

On Monday, Powell’s very first day as Federal Reserve chairman, the Dow Jones industrial average suffered its worst percentage drop since 2011. The selling has raged on in the days since, fuelled partly by fear that higher inflation would lead the Fed to accelerate its interest rates hikes and weaken the economy and the stock market.

All of which has left investors wondering what the Fed and its new leader might do now. Have they grown concerned about inflation? Will they step up their rate hikes—or perhaps slow them now in the face of investor anxiety and lower stock prices?

The worry that has seized investors is merely one of the issues Powell faces as he succeeds Janet Yellen as head of the world’s most influential central bank. Before becoming chairman, Powell had indicated he was inclined to follow the cautious stance toward rate hikes that was a hallmark of Yellen’s tenure. Yellen’s Fed kept rates near record lows and bought long-term bonds to lower borrowing rates for consumers and businesses and energize an economy levelled by the 2008 financial crisis.

Read: Fed leaves rate unchanged at Yellen’s final meeting

But as the plunge in markets showed, the path forward is likely to be trickier and perhaps riskier. The Fed’s perennial challenge is to keep rates high enough to prevent the economy from overheating and igniting inflation—but low enough to nurture healthy growth.

The central bank left rates unchanged in January at Yellen’s last meeting as chair. But it had signalled in December that it expected to raise rates three times in 2018, just as in 2017.

The turbulence coursing through markets has raised speculation that Fed officials might decide to slow their pace of rate increases out of fear of upsetting the markets and possibly harming the economy. But remarks some officials have made this week suggest that the Fed is most likely to stay the course.

“Having a bump like this has virtually no consequences in my view to the economic outlook,” William Dudley, president of the Fed’s New York regional bank, told reporters Wednesday. “My outlook hasn’t changed because the stock market is a little bit lower than it was a few days ago. It’s still up sharply from where it was a year ago.”

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Dudley said that his view would change if “the stock market were to do down precipitously and stay down,” because a sustained plunge could depress the economy’s growth prospects.

Robert Kaplan, president of the Fed’s Dallas regional bank, said he welcomed this week’s decline in stock prices, which many Fed officials and market analysts felt had reached unsustainable levels.

“I think it’s healthy that there is some correction,” Kaplan said in Frankfurt, Germany. “A little more volatility in markets […] can be a healthy thing.”

Charles Evans, president of the Fed’s Chicago bank, who had dissented from the Fed’s last rate hike in December, said he could support “three or even four” rate increases this year if he has more confidence that inflation has begun to move up.

David Jones, an author of several books on the Fed, is among analysts who say the Fed may actually be pleased that the stock market has retreated after a prolonged period of record highs that had raised fears of a dangerous asset bubble that could burst and derail the economy.

Wage gain surge

The market’s plunge was ignited by fear of potentially higher-than-expected inflation and interest rates. It began after the government reported Friday that average wage gains, which have been lacklustre for years, had surged 2.9% in the 12 months that ended in January. That was the sharpest such increase in eight years.

That’s good for workers. But it raised the concern that if the wage increase was heralding higher inflation ahead, then the Fed might accelerate its rate hikes out of concern that it needed to control inflation before it got out of hand. Faster Fed rate hikes would make stocks less attractive to some investors.

Many economists caution that they see little evidence that inflation is poised to rise too high. In fact, the Fed’s preferred inflation gauge shows that price increases remain below its 2% target level.

Before this week, many economists had begun to speculate that the Fed might raise rates four times this year if inflation measures edged closer to the 2% target level. The 12-month change in inflation in December was 1.7%. Some analysts have suggested that that figure was held down by temporary factors, including price wars among cellphone service providers.

A less dovish fed

Supporting the view that the Fed may raise rates a bit faster is that this year’s makeup of voters on the rate-setting committee includes fewer dovish officials, who favour maximizing employment and are usually less worried about inflation.

The voting makeup could become even less dovish depending on how President Donald Trump fills four vacancies on the Fed’s seven-member board. Trump has nominated Marvin Goodfriend, a conservative economist, for one of the vacancies.

Many economists think a Powell-led Fed may step up the pace of rate hikes if economic growth accelerates this year, boosted by the new $1.5-trillion tax cut package.

“I think Powell is going to be more concerned about where we are in the business cycle, with a very low unemployment rate, growth expected to be around 3% this year and stimulus from the Trump tax cuts,” Jones said.

Sung Won Sohn, an economics professor at California State University, Channel Islands, suggested that any likelihood of faster Fed rate hikes this year could quickly change if the market extends its fall in a sustained way.

“If the stock market were to fall by 20%, that would change Fed policy significantly,” Sohn said. “The psychology of the market place is much more fragile now than it was a week ago, and I don’t think it would take very much for what is still an overvalued stock market to go lower.”