Beckner: Global Downside Risks Could Alter Fed Policy If They Intensify

Written exclusively for InTouch Capital Markets

29th May 2018

By Steven K. Beckner

The Federal Reserve primarily pursues a domestic mandate of maximum employment and price stability, and its policymaking Federal Open Market Committee has been projecting at least three federal funds rate hikes this year as consistent with those goals. But Fed officials will be very carefully monitoring worrisome international developments.

Downside external risks could influence the FOMC to proceed more cautiously to the extent they become more manifest.

Fed policymakers were already warily eyeing trade tensions with China and others. Now, they must grapple with a prickly political situation in Italy. That debt-laden country’s failure to form a government led to a worldwide market sell-off Tuesday, as George Soros warned Italy’s woes pose an “existential crisis” for the European Union.

It’s premature to predict a break-up of the EU and the euro zone and to bet on a slower pace of Fed tightening as a result.

But it wouldn’t be the first time a foreign financial crisis with potential spillovers to the U.S. economy caused the FOMC to stay its hand.

After projecting three rate hikes at the start of 2015 and 2016, the FOMC raised the funds rate only once at the end of each of those years — in no small part because of untoward “financial and international developments.” That phrase remains in the FOMC’s list of factors it will assess in determining “the timing and size of future adjustments” to the funds rate.

After lifting off from the zero lower bound in December 2015, it was thought the FOMC would get going with funds rate “normalization” in earnest in 2016, but that plan was soon derailed.

New York Federal Reserve Bank President William Dudley explained why when I interviewed him in February 2016. He strongly hinted the Fed would be in no hurry to raise rates a second time by saying a weakening global economy accompanied by further dollar appreciation could have “significant consequences” for the U.S. economy.

“We’re acknowledging that things have happened in financial markets and in the flow of the economic data that may be in the process of altering the outlook for growth and the risk to the outlook for growth going forward,” Dudley told me.

Of course, the U.S. expansion is further along now; the global economic and financial system is arguably in better shape, and we don’t know how the Italian or other international situations will evolve. Markets are still pricing in high odds of a seventh funds rate hike when the FOMC meets June 12-13.

But going forward, it’s not inconceivable deteriorating international developments could affect the 2018 funds rate trajectory.

Even before the Italian political crisis ripened, Chairman Jerome Powell cautioned on May 8 that “risk sentiment will bear close watching as normalization proceeds around the world.”