New York Fed President William Dudley sketched out the face-saving formula that the Fed will employ to appear to raise interest rates without doing much of anything. Here’s what he said from the New York Fed’s text:

For financial markets, the likely path of short-term rates after lift-off is just as important as the timing of lift-off.  Here, I anticipate that the path will be relatively shallow.  Headwinds in the aftermath of the financial crisis are still in evidence, particularly the diminished availability and tougher terms for residential mortgage credit.

How fast the normalization process will proceed depends mainly on two factors: how the economy evolves and how financial market conditions respond to movements in the federal funds rate.  If financial market conditions do not tighten much in response to higher short-term interest rates, we might have to move more quickly.  After all, the point of raising short-term interest rates is to exert some restraint on financial market conditions.  In contrast, if financial conditions tighten unduly, then this will likely cause us to go much more slowly or even to pause for a while.  At the end of the day, we will move short-term interest rates to generate the set of financial market conditions that we deem is most consistent with our employment and inflation objectives.

How high will short-term rates ultimately need to go?  I think this issue is very difficult to judge for a number of reasons.  First, it depends on how financial market conditions evolve in response to our monetary policy adjustments.  Second, it depends on other factors, such as real potential GDP growth, which, in turn, depends on the growth rates of the labor force and of productivity.  My current thinking is that the long-run nominal federal funds rate consistent with 2 percent inflation is somewhat lower than in the past.  My point estimate is 3½ percent, but I wouldn’t bet the farm on this.  I have considerable uncertainty about this estimate.

The market is starting to get the idea. The Fed doesn’t want to be perceived as weak, so it gives the market what it wants without actually doing much (think of Obama and the Iran nuclear program). First it was removing the “patient” qualifier in order to look tough but reducing the year-end fed funds forecast. Now it’s the “shallow” trajectory of interest rates. If the market thinks the FOMC is going to raise the funds rate by 25 bps and then take off to an ashram for two years of meditation before raising rates again, it doesn’t particularly care.

Dudley puts Q1 GDP growth at 1%, the Atlanta Fed’s GDPNow tracking model at 0%. The point is that US growth is struggling along at sub-2% in the face of a strong dollar (crushes exports), ,cheap oil (crushes CapEx), and reluctant consumers.

That said, services are still expanding while goods-producing contracts. Today’s ISM non-manufacturing survey confirms what we saw in the Friday employment report.


While manufacturing languishes just above the 51 mark on the ISM survey, all the service indicators are comfortably in the mid-50s, indicating moderate expansion. That’s subpar growth but not a new recession.

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