Are Financial Markets Too Pessimistic About the Economy?
In a speech at Central Connecticut State University, Boston Fed President Eric Rosengren said the U.S. economy is fundamentally sound, weathering headwinds from abroad, and likely to perform better than the domestic economies of most trading partners.
"This represents an outlook strong enough to engender further decline in the unemployment rate, even with some gradual normalization of interest rates," Rosengren said.
However, pricing in the federal funds futures market implies just three-quarters of a percentage point in increases by the end of 2018—one quarter of a percentage point increase in each of the next three years. This is inconsistent with Rosengren’s forecast—and that of many forecasters—for continued moderate growth in the U.S. economy.
"While I believe that gradual federal funds rate increases are absolutely appropriate, I do not see that the risks are so elevated, nor the outlook so pessimistic, as to justify the exceptionally shallow interest rate path currently reflected in financial futures markets," Rosengren said.
Looking at longer-term market rates, Rosengren also noted that market rates on 10-year Treasury securities are below 2 percent. If the Fed is successful in averaging 2 percent inflation over the next 10 years, then investors are accepting a negative real rate of return.
In Rosengren’s view, it is quite appropriate to probe how low unemployment—currently at 5 percent—can go, given that the inflation rate is below the Federal Reserve’s 2 percent target and wages are only increasing modestly. One reason for probing how low the unemployment rate can go is that it will encourage more people to return to the labor force.
But given these conditions, an interest rate path as shallow as implied in futures markets could introduce risks of overheating.
"A large, rapid decline in unemployment could be risky, as an overheating economy would eventually produce inflation rising above our 2 percent goal."
"I would prefer that the Federal Reserve not risk making the mistake of significantly overshooting the full employment level, resulting in the need to rapidly raise interest rates—with potentially disruptive effects and an increased risk of a recession."
"At the Boston Federal Reserve Bank we have been expecting only a slow decline in the unemployment rate, a forecast in part predicated on people being drawn into the labor force," Rosengren said. "Our model has assumed that real GDP growth somewhat over 2 percent will be consistent with some gradual further decline in the unemployment rate."
Rosengren delivered the American Savings Foundation Distinguished Lecture at Central Connecticut State University.