The Fed Should Make a Boring Statement, Despite Rising Inflation

(Bloomberg) -- The Federal Reserve has successfully led financial markets to price in its baseline interest rate signals for 2018. In concluding the Federal Open Market Committee meeting on Wednesday, policy makers will face the important question of how far to go in moderating expectations of rate rises beyond the baseline, and whether to counter the growing conviction among investors that the central bank is no longer in the business of providing a tight backstop for volatile stock markets.

The Fed shouldn't go much beyond welcoming recent inflation data and reiterating its prior policy guidance. It can do so by issuing an appropriately boring statement.

On Monday, Fed policy makers received welcome news that their favorite inflation gauge, the personal consumption expenditure rate, rose in March. The overall index reached 2 percent, up from 1.7 percent for February, and the core measure climbed to 1.9 percent, from 1.6 percent. That means annual inflation is again hovering at the 2 percent Fed target last touched briefly in February 2017. This coincides with medium-term market expectations reflected in the breakeven rates for Treasury Inflation-Protected Securities that are consistent with the central bank's inflation goal.

If the 2 percent level is sustained this time — and it isn't certain to be given relatively anemic wage growth — the Fed would have a solid case to declare “mission accomplished” on its dual mandate of maximum sustainable employment and stable prices. That realization has pushed markets to fully price in the previously signaled path of rate hikes for 2018 as a baseline, and to tilt the balance of risks markedly in favor of a fourth rate increase.

There is also the question of stock market volatility. Unlike during many previous bouts of unsettled prices, the central bank now is more comfortable about living with larger two-way price movements, and policy makers have shown no appetite to return to the practice of making soothing statements to calm markets.

Yet the Fed's success in convincing markets of a more rapid return to “normal” monetary conditions also carries risks: a tightening in financial conditions that is too fast and too sharp could constitute a damaging headwind. The economy still has elements of structural slack (a labor participation rate just below 63 percent) and faces possible operating-regime shifts (including on account of trade negotiations, eroding growth momentum in Europe and the overpromising of liquidity in certain market segments). In addition, it operates in a fluid landscape created by the impact of technology and shifting debt dynamics, along with political and geopolitical uncertainty. 

In welcoming the gradual and continued dissipation of “lowflation” concerns, the Fed's challenge after so many years of excessive reliance on unconventional measures remains to maintain a steady hand to complete a highly successful “beautiful normalization” of monetary policy. This requires a delicate balance between inadvertently amplifying the markets' tendency to price in an extra rate hike for 2018 and prematurely suggesting that some moderation of the tightening policy bias may be needed.

Given there policy circumstances, less is more. That is why the Fed should err on the side of a uneventful outcome to this week's policy meeting by: 

• Holding off on a rate hike until June.

• Making only minor changes to the statement when it comes to the economy's overall prospects, while slightly upgrading the language on inflation.

• Refraining for now from signaling anything new on the so-called neutral rate.

• Continuing to maintain the same policy optionality it has signaled in the past.

• Minimizing — or even better, keeping to zero — any dissenting votes among FOMC members.

• Leaving alone the previously communicated plan for balance sheet reduction.

Since the 2013 “taper tantrum,” the Fed has gotten much better at striking inherently delicate policy balances. The payoff has been the ability to normalize policy without derailing economic growth or causing major disruptions to financial markets.

To contact the author of this story: Mohamed A. El-Erian at melerian@bloomberg.net.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

©2018 Bloomberg L.P.