The Fed Will Pause
We now expect the Fed will delay hiking the funds rate target range to 2.50-2.75% until Q3 rather than Q2. As a consequence, the subsequent hike, to 2.75-3.00%, will come in Q4 rather than Q3.
Fed officials have emphasized patience regarding rate hikes in recent statements. The minutes of the December 18-19 FOMC meeting also indicate increased caution regarding the economic and policy outlook. Even moderately hawkish policy makers, such as Chicago Fed President Charles Evans and Philadelphia Fed President Loretta Mester, have suggested a delay in hiking rates. Evans said that waiting six month before hiking rates might be a good idea. Guidance that explicit cannot be ignored.
The Fed Will Resume Hikes If Risks Diminish
At the same time, Fed officials rightly note that domestic economic conditions are quite healthy. Were it not for financial market weakness and economic weakness abroad, the Fed would still be on track for three rate hikes this year, with little inclination to delay. If financials markets calm down and risks to the economy diminish, for instance as the result of a trade agreement with China, then the Fed will be ready to resume hiking toward whatever level seems consistent with domestic economic conditions. The real fed funds rate remains very close to zero (Figure 2), far lower than the peak of any prior cycle; in the absence of serious downside risks, that gives the Fed reason to hike rates further.
Risks to Our View
The greater risk, for now, is a further delay in rate hikes. The Fed would delay further if conditions deteriorate, but may also delay further if conditions simply do not improve. In addition, growth risk are generally skewed to the downside late in the cycle, when the output gap is zero or positive and imbalances have had time to build. Only if there were a steady upward climb of inflation would there be a serious risk that the Fed would accelerate rate hikes.
Figure 2: Real Fed Funds Rate Well Below Every Prior Peak
Source: Federal Reserve Board, Bureau of Labor Statistics, Continuum Economics