Why the Federal Reserve’s indecision to raise rates?

By Blu Putnam, chief economist, CME Group

The US Federal Reserve appears ready to raise itstarget federal funds rate for the first time in a decade, even if it is stilltoying with the markets about timing. Job creation and the unemployment rate are flashing a clear green.  Core inflation is still a little below theFed’s long-term 2% target, but easily within measurement error distance.  US 10-year Treasury notes yield above 2%,suggesting a lack of deflation fears.  So,why the wait?  Why the indecision?

We like the doctor-patient illustration.  The Fed seems to view the US economy like ahospital patient that suffered a severe heart attack.  The patient was admitted to the intensivecare unit back in late 2008.  Financialpanic was sweeping the globe, with the very messy bankruptcy of Lehman Brothersand the unprecedented and highly unusual bailout of AIG back in September 2008.  The patient was admitted to the intensivecare unit at the hospital.  Emergency treatments,including zero rates and multiple rounds of quantitative easing, wereprescribed.  As the condition of the patientimproved, the QE programs were ended in the fall of 2014.  So now the only question is whether thepatient is healthy enough to walk out of the hospital without the need of anyfurther emergency measures, such as zero rates.  

The Fed, however, is a conservative doctor, in thatthey do not want to make a mistake and release the patient too early.  And, while the vital signs, such asemployment are strong, one can always find reasons to worry. 

Hourly wages are barely growing and laborparticipation rates are falling.  Wethink these factors are structural, reflecting an aging economy dealing withthe rise of e-commerce, among other factors. The Fed may have some influence over long-term inflation and economicgrowth, but things like labor participation rates and hourly wages are outsidethe Fed’s direct influence.

And then, every treatment program has itsside-effects.  Zero short-term ratespenalizes savers, especially retirees. Removing this distortion may even help boost consumption, since with littleto no income coming from fixed income portfolios, savings rates have needed torise for parts of an aging population increasingly worried about retirement.  And, the evidence that zero rates andquantitative easing provided much stimulus to the economy remains highlydebatable.  What has been more evident,however, is that QE and zero rates probably have had their impact on prices offinancial assets, including stocks and bonds.  That is, continuing the Fed’s emergency policies long after economic growthhas resumed runs an increasing danger of encouraging market participants totake on more risk in search of returns than may be prudent.

Taken all together, the Fed finally seems ready toagree to a compromise arrangement between its “hawks” (i.e., those who wantedto abandon zero rates a long time ago) and its “doves” (i.e., those who feelthere is little harm in waiting longer). The compromise arrangement seems to be that short-term rates can bepushed higher if the pace is very slow and incremental.   Once the first step is taken, the Fed mayskip one or two meetings between rate increases, although the 0.25% per step islikely to stay.  Also, the Fed does notappear to have any intention of raising rates very high.  This time around the Fed might move rates tobetween 1.5% and 2.0% and simply stop, possibly for a year or more, and watchthe inflation and jobs data to see what develops.

Also, we need to ask what the economic and marketimpact might be of a slow path to slightly higher short-term rates?  Unless one has been hiding under a rock,everyone has probably gotten the email that at some point, rates are goingup.  Such a well-telegraphed decision,even with uncertain timing, probably means that the market reaction will bemuted. 

Finally, we need to ask what might happen to delay theFed further.

Greece was a distraction, for sure.  The European Central Bank (ECB) was createdto manage and protect the single currency. The ECB can probably be relied upon to do whatever it takes to make sureany fallout from a Greek tragedy will not spillover in the EU economy or hurtthe Euro.

China is also a risk. The Chinese economy has been decelerating over the last several years,and further deceleration seems likely. Also, the Chinese stock market has been on an impressive roller-coasterride.  There is no sign, however, thatthe Fed would delay a rate rise decision based on Chinese economic data unlessit thought, in the extreme case, that a Chinese recession was coming and itwould cause the US to go into recession. This is highly unlikely.

The base case scenario seems to be that the Yellen-Fedis just about ready, possibly in September 2015, to put the legacy emergencypolicies of the Bernanke-Fed behind it. And if not September, then October or December seem likely candidates.