The Fed is worried about risks to the economy

[thenews]

Minutes of the Federal Reserve's January meeting showed that the policy-setting committee saw more downside risks for the US economy.

The Federal Open Market Committee (FOMC) acknowledged that the labor market had strengthened since its December meeting, even as economic growth slowed in the fourth quarter.

However, Fed staff lowered their outlook for short-term inflation on concern that the strong dollar and low oil prices, though considered transitory, could keep the 2% target further off.

Here are the key portions of the minutes (emphasis added):

The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff's assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks; the downside risks to the forecast of economic activity were seen as more pronounced than in December, mainly reflecting the greater uncertainty about global economic prospects and the financial market turbulence in the United States and abroad. Participants judged that the overall implication of these developments for the outlook for domestic economic activity was unclear, but they agreed that uncertainty had increased, and many saw these developments as increasing the downside risks to the outlook.

Still, the FOMC's appraisal of the economy was consistent with a strengthening labor market late last year.

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[thenews]

FOMC Minutes: Dovish Tilt On Increased Risks According to the FOMC minutes, many members judged that uncertainty had increased although evidently available information was not yet sufficient to assess balance of risks. So basically the reason why the Fed didn’t provide an assessment of the balance of risk in the January statement was because it still is early days and officials were too uncertain how to accurately read the situation. Indeed, there is no reason for the Fed not to keep all options open; it is data-dependent after all and will collect and assess incoming data right up to the March meeting before making its decision.

That said, many officials saw increased downside risks in January already. You knowthe thing with the tightening in financial conditions is that it will not affect growth and inflation prospects immediately but the key is if the tightening will prove persistent or not. Another cause of concern for a number of officials is the situation in China, a slowdown in the Chinese economy would clearly be a negative for US economic outlook.

While the above suggests a dovish tilt concerning the risk to the outlook, officials generally continued to expect a gradual tightening of monetary policy. Basically the reason why officials such as Yellen and Dudley keep suggesting that the gradual approach is the most appropriate even now is that it actually would decrease the probability of a recession; the unemployment rate is at the NAIRU already and if the Fed waits too long the labor market overheats. Should that happen if history is any guide it will be impossible to properly manage the situation without the unemployment rate sky-rocketing and the economy plunging into recession anyway – Dudley elaborated on that last month for example.

However, a hike in March seems very unlikely at this juncture basically since the Fed clearly has not made enough of an effort to communicate that possibility to markets. Actually at one point last week, the probability of a rate cut was bigger than a rate hike according to future markets. We still expect two hikes this year, in September and December respectively.

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