I agree with Tim Duy but my reasons differ

Genevieve Signoret

Tim Duy speculates as to what it would mean if the FOMC hiked rates by 25 basis points to 0.25–0.50% on September 17 even though inflation is below and diverging away from the 2% Fed target and no observable signs have emerged that inflation pressures are building. He argues that an initial 25 basis-point lift-off in the federal funds target range would in fact be meaningful despite its small magnitude, as it would teach us something new about the Fed’s reaction function—in particular, that the Fed had increased its confidence around its 5.0–5.2% estimate of the natural rate of unemployment. If the Fed hikes already in September even while inflation is drifting down away from the Fed target of 2%, he reasons, it can only be that the Fed is becoming convinced that the unemployment rate is nearly low enough to render consumer price acceleration inevitable. I agree with Tim that a 25-basis-point rate hike would be a meaningful market event, but my reasons differ.

I agree that, based on the unemployment rate, FOMC members figure that inflationary pressures so far invisible must be building. Up to here my thinking matches that of Tim. But, unlike Tim, I don’t think that their views on labor market slack is the primary force driving their eagerness to hike. I think it’s their strong urge to normalize.

I understand normalize to mean instigate a policy regime switch from the Fed’s current tool kit built for a liquidity trap (ZIRP plus balance sheet size) not back to the old one (a target federal funds target rate) but rather to a new, more sophisticated freshly designed one (three rates at first, including the federal funds rate; later, two).

Normalizing is a project to the Fed looming large and lengthy. They have planned it meticulously. Tested tools scrupulously. Waited for months. Now not only are staffers chomping at the bit operationally, but also FOMC members fret that hidden inflation pressures may cause an unforeseen eruption before they’ve become agile at deploying their new tools. They feel an urge to act, and step one is revive the federal funds rate. 25 basis points is all it would take; it’s enough to launch.

A thorny challenge lies ahead, however: how to communicate with markets about normalization so as to prevent an overreaction. Think back to tapering. The term referred not to tightening but rather to a gradually winding down of the monthly pace at which the Fed added new stimulus. Yet, to many market participants, tapering sounded like a euphemism for tightening. And, even for savvier ones, it spelled doom, as it meant that actual tightening now loomed closer. These thoughts triggered a tantrum.

But, just as tapering did not mean tightening, normalizing does not mean that the Fed will necessarily adopt a tight monetary stance any time soon. It will require a small lift up off the floor, but 25 basis points will do it. Beyond 25 basis points, in theory, the future path is data dependent entirely: normalization can lead to a tight stance but need not do so right away, not if macro conditions don’t warrant it.

This I think is what FOMC members mean when they urge us to stop obsessing over 25 basis points. But how to explain this to markets? Their task is tough, for three reasons:

First, although the Fed has pilot-tested its two new tools, the interest rate on excess reserves (OER) and the ON RRP facility, markets correctly note that the Fed is moving into uncharted territory.

Second, New Toolkit for Normal Times is complex: three rates at first; two later on; a target range.

Third, implementation involves a series of first-time events: an initial rate hike to a new target range with the introduction of two new rates to establish a corridor; a subsequent phasing out of one of the two new rates; passive shrinkage of the balance sheet.

I think the Fed despairs of making this market-smooth—they figure they must simply take the plunge, explaining and illustrating as they go. Markets will writhe and yelp in discomfort at first, yes, but eventually “get it” and settle down, just as they did weeks into tapering.

I must say, I sympathize with (my imagined) Fed fretting that market reactions to liftoff probably will prove tumultuous in disproportion to the wee size of the first hike. Rate hike math captures this overreaction. Think of the current rate as simply 0%. Then, any hike, no matter how small, in percentage terms is infinitely large. We’re talking about regime change here; discontinuity.

In short, Tim Duy and I agree that a 25–basis-point hike in September even while inflation’s low and drifting down would matter but differ as to why. He thinks it would tell us something new about the Fed’s reaction function. I say it would mean the Fed could contain its urge to normalize no longer. And that markets will think normalize means go all the way tight when in fact it means merely change tools. And will throw another tantrum.