December 16, 2018 / 1:31 PM / a month ago

Will landing be soft or 'chaotic' as Fed begins to stop rate hike cycle

WASHINGTON/SAN FRANCISCO (Reuters) - In June 2006, the U.S. Federal Reserve raised interest rates for a 17th consecutive time but cushioned the increase with a strong signal that officials were ready to stop the tightening cycle.

FILE PHOTO: FILE PHOTO: A cyclist passes the Federal Reserve building in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie/File Photo/File Photo

Each rate increase in the previous two years had come with a cue that the U.S. central bank would continue to lift borrowing costs, but at that policy meeting the Fed said any additional hikes would “depend on the evolution” of the economy.

Now, as 2018 winds down with three rate increases on the books and another expected at the end of the Dec. 18-19 policy meeting, the Fed may be similarly preparing to call time on a rate hike cycle that has proved remarkable for its tepid pace.

Although the Fed had hoped to return its benchmark overnight lending rate to “normal” when it embarked on its tightening cycle three years ago, it may end up stranded at about half the 2006 level and well below the average from the 1950s to 2007. The Fed has raised rates eight times since 2015.

Investors and leading Fed analysts have spent the last month adjusting their outlooks as a familiar set of risks took root.

Oil prices have plunged. Stock markets are wobbly. There are fears slowing global growth will weigh on a U.S. economy already expected to decelerate. Inflation, watched closely by the Fed, may be weakening.

A Reuters poll on Friday showed economists marking up the probability of a U.S. recession in the next two years to 40 percent from 35 percent previously.

They now expect the Fed to both pare its three anticipated rate increases for next year to two or even fewer. The central bank may also ditch its longstanding pledge that “further gradual increases” in rates will be needed to keep the economy on track and inflation under control.

More hikes may well be necessary in a growing economy with unemployment at a 49-year low. Some policymakers remain concerned that a scarcity of workers will bid up wages and lead to more quickly rising prices that the Fed needs to head off.

But until that becomes clearer, analysts, investors and Fed officials seem in agreement that Fed Chairman Jerome Powell wants to be as unshackled as possible to respond to events.

“Financial markets have clearly decided things look a little less strong. China looks softer. Europe looks softer. Brexit looks a bigger risk,” said William English, a Yale University economics professor and the former head of the Fed’s monetary affairs division. “They are taking that on board.”

FAR ENOUGH FROM ZERO?

A Fed signal that its rate hike cycle is ending would be cheered by home buyers, corporate debt managers, stock markets and others eager for borrowing costs to stay low. It would be welcomed by U.S. President Donald Trump, who has frequently groused that the Fed is raining on his economic parade.

Inside the Fed, however, it would be an unsettling end to a process that began in December 2008 when policymakers cut the federal funds rate to near zero to fight a raging economic and financial crisis. Ben Bernanke, the Fed’s chairman at the time, called that move “the end of the old regime.”

Still, few expected that rates would still be this low 10 years later.

If the Fed’s targeted interest rate does peak at around 3 percent, or roughly half its average from the 1950s through 2007, it means that even “tight” policy means historically cheap money.

The federal funds rate remains so low, in fact, it may crimp the ability to fight a future recession, distort how markets price risk, and leave household savers stuck with bank deposit earnings that can’t keep pace with inflation.

The Fed’s intent for this next phase will be seen in its upcoming policy statement, with the focus on whatever language replaces the prospect of “further gradual increases” in rates, as well as in a fresh set of policymakers’ economic projections.

Both are due to be released at 2 p.m. EST (1900 GMT) on Wednesday. Powell is scheduled to hold a press conference shortly after.

The median expected federal funds rate for the end of next year currently sits at 3.1 percent, about a percentage point beyond the current range of 2.00 percent to 2.25 percent. That would imply one quarter-point hike on Wednesday and three more in 2019.

That expectation was set in September, before a recent bout of stock market volatility and rising worries about the global economy. Many analysts expect the Fed to shave at least one rate hike off that pace. Investors in fed funds contracts are even bigger doubters, betting on only one rate increase next year.

It wouldn’t be the first time in recent years that markets have helped put the Fed on hold, even as the U.S. economy motored along during its near decade-long expansion.

A selloff of global stocks, weak oil prices and a strong dollar - which held down inflation and curbed U.S. exports - in 2015 and 2016 led a Fed that had expected eight rate increases over those two years to deliver only two.

As markets steer in one direction, the economy keeps performing, and Powell prepares to set his own language for how, and how far in advance, to signal future Fed actions, Tim Duy, a University of Oregon economics professor, sees a “chaotic” period ahead.

“Everyone is fairly bearish right now,” Duy said. “Powell has repeatedly said the economy is strong ... We are all going to be asking, when are you going to hike next?”

Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao

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