The Fed’s delicate task

Janet Yellen Image copyright Reuters

The Federal Reserve's latest statement suggests that the path is clear for an interest rate rise in June or September without surprising markets.

Rather amusingly, it's because the word "patience" was removed from the statement. Of course, it depends on how far the US labour market improves since inflation isn't an issue, so the jobs market looms larger for the US central bank with its dual mandate to address unemployment and inflation.

Still, looking at the forecasts of the individual rate setters, the median projection is for the interest rate to end the year at 0.625%, so that's a rate rise from the current 0-0.25%.

Markets were expecting this, which helps. Stocks rallied in part because the rate raise may not be very soon, as the US economy is weaker than the rate setters thought back in December. The key forecasts for the economy and inflation were all downgraded. Now, the US economy is expected to grow by 2.3-2.7% versus a top growth rate of 3% in the December forecasts. Inflation is also expected to be below the Fed's 2% target through 2016 when it may hover between 1.5-1.9%.

No repeat history

Indeed, investors don't like to be surprised, so part of what the Fed has to do is to manage expectations. And one of the concerns that's percolating right now is whether Fed raising rates or tightening could result in a repeat of the 1930's.

The period between 1937-1938 is known as a recession within a recession. It's when the US fell back into recession eight years after the 1929 stock market crash and the Great Depression. It happened after four years of cash printing, which pushed up stock prices.

In 1936, the Fed started to worry about its "exit strategy". When it started to tighten the money supply in 1937, it coincided with the end of a fiscal stimulus that reduced the budget deficit by some 2.5% of GDP. Unemployment soared again to 19% after falling to 14% from 25%, and the Dow Jones lost around one-third of its value during the sharp economic slump of 1937-38.

If it all sounds too familiar for comfort, that's why some are concerned about the Fed's move toward "normalising" interest rates, as it moves rates above 0% and back to pre-crisis levels. The last rate hike was eight years ago in 2007 and it's been at rock bottom pretty much since the 2008 financial crisis and the ensuing recession dubbed the Great Recession.

It shouldn't be surprising that the Fed will contemplate raising rates as it has been a long recovery. The delicate part is to manage expectations. But more than that, it's also ensuring that the economy is on a solid enough footing to normalise interest rates.

Acting prematurely could cause the Great Recession to truly parallel the Great Depression.

With growth and inflation both downgraded, but unemployment moving in the right direction, judging what "premature" means is no easy task. And communicating it to investors will also be crucial.