The 'new normal' in monetary policy is anything but

A funny thing happened on the way to normal. The Federal Reserve Bank's first interest-rate hike in almost 10 years was supposed to be a first step on the path toward a more "normal" monetary policy, a sign the economy no longer needed the life support of zero interest rates.

With financial markets now swinging wildly and other central banks experimenting with negative interest rates to jump-start morbid economies, the Fed's first step toward normalcy may be its last for some time. Fed Chair Janet Yellen was cheered for her measured explanation of the December rate hike, but the market quickly soured on the idea of tighter monetary policy.

Fed Chair Janet Yellen
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Fed Chair Janet Yellen

"She went from being a hero to a villain in very short order," said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management. "With the information the Fed had in December, a rate hike was the right choice.

"If they now leave rates where they are or even cut them, it shows that they're data-dependent and more power to them," he added.

The data, in this case, were falling stock prices and widening credit spreads. The minutes from the last two Fed meetings suggest that volatility and tightening financial conditions alarmed Yellen and other committee members.

They have already chosen not to raise rates any further in their last two meetings, and the market puts the chances of a rate hike at the end of April at zero, based on Fed Funds futures prices on the Chicago Mercantile Exchange. It doesn't give a more than 50 percent chance of another hike by the Fed until the December meeting.

As for returning to a more "normal" monetary policy, however, don't hold your breath. "It's a long road back to normal," Jacobsen said. "We could be looking at up to six years before we get back to what might be considered a normal monetary environment."

Peter Schiff, an unrelenting critic of the Fed and one of the gloomiest analysts of the stock market, thinks the U.S. central bank has no choice but to back off from raising rates any further.

"The Fed has to be careful. If the dollar falls from here and energy prices rise, inflation could pick up in a hurry." -Bob Johnson, director of economic analysis at Morningstar

"The market is having convulsions, and to stop them, the Fed has to give the drugs back," said Schiff, CEO of Euro Pacific Capital. "The whole reason for quantitative easing [QE] was to prop up the stock market. If that wealth goes away, all their work of the last six years goes to waste."

Schiff believes the Fed's response to the financial crisis was wrong-headed from the beginning. It was wrong to pull rates down to zero, wrong to flood the markets with cash through its bond-buying QE programs and even wrong to bail out the banking industry when it was on the verge of collapse. It only served to create new asset bubbles and to delay a day of reckoning. It also set the table for the very weak economic recovery of the last five years.

"This recovery was about cheap money, not economic fundamentals," said Schiff, suggesting that the non-service sector in the United States is already in recession. "We should have bitten the bullet back in 2008. Now we're facing something worse than that," he added.

Bob Johnson, director of economic analysis at research firm Morningstar, isn't as dour about the economy. He thinks a number of temporary factors — such as turmoil in energy markets, warm weather depressing utility revenues and the strong dollar hurting exports — caused the weak fourth-quarter GDP number of 0.7 percent growth.

Johnson expects the economy to bounce back in the first quarter to the 2 percent to 2.5 percent growth track it has experienced over the last four years.

"We're not accelerating, but we're not falling apart, either," he said. "Economic weakness will not be the reason to hold back on raising rates."

Johnson said that while headline inflation remains weak, thanks to energy prices, core inflation is more significant, and inflation in service industries is already well above the Fed's stated 2 percent target. He also noted that 2.5 percent real wage growth could put further pressure on prices, particularly in service industries that have little foreign competition.

"The Fed has to be careful," said Johnson. "If the dollar falls from here and energy prices rise, inflation could pick up in a hurry." Johnson thinks the Fed could still raise rates two or even three times this year.

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That would be normal six years into an economic recovery. The problem with rate hikes, however, is the extreme sensitivity that financial markets have to the idea. Since the December rate hike, volatility in the stock market picked up dramatically and credit spreads widened further. Market sentiment reversed just as dramatically when Yellen and the Fed indicated that the volatility had changed their views on further rate hikes.

"Financial conditions matter, and in her latest testimony, [Chairwoman] Yellen said they weren't conducive to growth and the Fed's inflation objective," said Wells Fargo's Jacobsen, who believes the Fed will wait for oil prices and the U.S. dollar to stabilize more convincingly before they hike rates again.

"The Fed has always been sensitive to U.S. and global financial conditions," he said. "It's just a lot more in the public eye now."

The Fed also has to consider what other central bankers are doing. The Bank of Japan joined several European countries and the European Central Bank in putting negative interest rates into effect.

"We live in an interconnected world," Jacobsen said. "What the Fed does depends on what other central bankers do, too." Capital has already been flowing into U.S. financial markets, driving long-term Treasury rates down just as the Fed begins pushing short-term rates up.

Further policy divergence with the rest of the world could cause more problems. "If the Bank of Japan goes more negative, that may put the Fed on pause for even longer," Jacobsen said.

There is also the matter of the Fed's abnormally large portfolio of about $2.4 trillion in Treasury bonds and mortgage-backed securities. For now, the Fed continues to reinvest the proceeds from maturing bonds back into new securities.

Jacobsen expected it might stop doing that by the end of this year, but absent robust growth in the coming quarters, he thinks it will be pushed out to 2017. If the economy goes into a recession — a 10 percent likelihood, in Jacobsen's estimation — he thinks the Fed could launch another quantitative easing program [QE 4] to help support it.

"We've seen the positive aspects of quantitative easing," said Morningstar's Johnson. "The challenge now is to get back to normal without affecting financial markets too negatively."

— By Andrew Osterland, special to