Where have all the rate hikes gone?
At this time two years ago, the median projection of the members of the Federal Open Market Committee was for the appropriate target federal funds rate to be 2.875 percent at the end of 2016, and 3.750 percent as 2017 came to a close. Not one of the September 2014 meeting's participants expected the appropriate rate to be below 2.0 come Christmas 2017.
Fast forward to last week's meeting, in which the Fed choose to keep its rate target at 0.25 to 0.5 percent, and the median projection is for the appropriate fed funds rate to be 1.1 percent at the end of next year — with most projections coming in the range of 1.4 percent to 1.9 percent.
"The FOMC has been too optimistic for many years," Deutsche Bank chief international economist Torsten Slok said in a recent research note.
Notably, the word is "optimistic," since the conflict has been between the Fed's economic expectations and reality, not between its policy preference then and now. While unemployment has actually fallen further than expected, the Fed's expectations for GDP growth and especially for inflation have proven a bit too hopeful.
"There are two competing explanations of why this expansion has been so weak," Slok said Wednesday on CNBC's "Trading Nation."
"The first explanation is that we have been facing some headwinds from a cleanup in the banking sector, from a cleanup in the housing market, and from a cleanup of consumer balance sheets, and once those headwinds are fading, then that explanation would say that we should see accelerating growth," Slok said.
"The second explanation," Slok continued, "is that we are now seeing a shift toward stories about productivity growth being weak about demographics being headwinds. So one story says that this is just temporary weak growth and then we'll be off to the races again, but the other story that's catching on is this permanent fear that maybe we are in a structurally low growth environment."
Slok said that while the Fed is "struggling to understand which of these two stories is the right one," the second, more dire explanation — a form of which has been made famous by economist Larry Summers under the borrowed banner "secular stagnation" — is "becoming much more pronounced."
Indeed, the Fed's long-term GDP growth projections have fallen dramatically, as have its expectations for an appropriate rate level, which could suggest they are buying into the latter thesis.
This question obviously has salient implications for Fed policy, since in the first case, the economy could threaten to overheat if rates are kept too low for too long, but in the second, lower rates are simply more appropriate, and inflation is not a major concern.
Slok does expect that the Fed will raise rates one more time before the year is out. However, if the Fed begins to suspect that there is a serious and more secular problem with the economy, the central bank may have a substantially less compelling case for doing so.