Global turmoil complicates Fed’s rate-hike timetable

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On its road to normalizing its still far-from-normal interest rates, the U.S. Federal Reserve Board has clearly grown worried that global financial-market turmoil could knock it into the ditch. Which itself is as good a reason as any for Fed Chair Janet Yellen to go easy on the rate throttle.

No one expected Ms. Yellen's testimony Wednesday to the U.S. House financial services committee to clear up what has become one of the most burning questions in the tumultuous start to 2016: whether the Fed, having at long last initiated interest-rate increases in December, is going to be forced to abandon further hikes in light of the global economic and market uncertainty that has begun to infect the U.S. recovery.

She stressed, again, that the Fed plans to take its time with raising its benchmark federal funds rate further from its still-minuscule target range of 0.25 per cent to 0.5 per cent, and that it has no preset timetable for further increases. She talked about both upside and downside risks that could either speed up or slow down the pace of the U.S. economic recovery, although it didn't escape Fed watchers that she spent more time talking about the negatives than the positives.

By the same token, though, she defended the Fed's December position to start raising rates, and reiterated that the central bank still intends further rate hikes. And she poured about as much cold water as she could on the growing rumblings that the Fed might change course entirely and cut rates, in response to the pronounced slowing of U.S. economic growth.

"I do not expect the FOMC [the Fed's policy-setting Federal Open Market Committee] is going to be soon in the situation where it is necessary to cut rates," she said. She noted that while the markets seem to have become increasingly concerned about the risk of another recession, the U.S. and global economies haven't shown the kind of drop-off to support such fears.

Still, those market worries are themselves posing a risk to the outlook. If there's anything for the U.S. economy to fear, apparently, it's fear itself.

"Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers and a further appreciation of the dollar. These developments, if they prove persistent, could weigh on the outlook for economic activity and the labour market," she said.

Ms. Yellen laid the blame for this financial-market turmoil on China's exchange-rate policies and plunging oil prices; but she could have looked in the mirror while she was at it. The Fed's December rate increase, coming at a time when most major central banks in the world (including Canada) have been easing their monetary policy, has provided the flame that's keeping the U.S. dollar on the boil. At the same time, growing uncertainty surrounding the trajectory of future Fed rate increases has been a major variable lurking behind the market gyrations ever since the December move. Expectations have swung from a likely follow-up increase by March to now near-zero odds of anything before midyear, with a low likelihood of any rate rise at all this year.

Ms. Yellen's comments Wednesday largely eliminated the slim chance of a rate cut that was priced into the market; but, if anything, they reinforced the belief that another hike any time soon is a long shot. The bond market is now pricing in a less-than-one-in-four chance of an increase before December.

This sense that the Fed is retreating from its rate-raising path has probably been the biggest element in the Canadian dollar's recent rebound. Yes, the turnaround in oil prices was another big factor, but the currency has held onto its gains despite this month's renewed weakness in crude. The fading expectations surrounding the Fed, coupled with indications from the Bank of Canada suggesting it isn't predisposed to further cuts itself, have swung the relative rate outlook between the two countries more in Canada's favour, at least for the short term.

And maybe a retreat is the best thing the Fed can do right now. The U.S. economic recovery has been looking increasingly fragile: Over the second half of 2015, the Fed estimates, growth was just 1.25 per cent annualized. For the fourth quarter, the U.S. government's initial estimate pegged the growth pace at a tiny 0.7 per cent. If, as Ms. Yellen argues, market instability is creating another headwind for the U.S. economy, then the Fed hardly needs to add to those headwinds by leaving rate increases as a massive variable at play in those markets.

She doesn't have to, anyway – and the markets are starting to realize that. In her testimony, Ms. Yellen stressed, as she has many times now, that the Fed's rate decisions are "data dependent" – the central bank will adjust the federal funds rate only if and when the economic indicators warrant. The data say the Fed is on the sidelines until further notice. Perhaps markets, too, can put the Fed rate question on the back burner for a while and focus on their other worries.