U.S. Federal Reserve officials are worrying about inflation and have signaled more rate hikes at the risk of reversing the nine-year economic expansion.

The Fed may be tightening monetary policy too much and too quickly, and further increases in interest rates could adversely impact the economy. President Trump has in recent weeks criticized Fed Chair Powell for the rate increases and blamed an “out of control” U.S. central bank for the worst stock market sell-off since 2008. The key question is whether Trump may be right. Has the Fed done too much? Is all the Fed commentary about “moving beyond neutral” appropriate? Will this end in tears, as so many central bank tightening episodes have in the past?

Already, interest rates have risen materially. Real rates are now pushing into territory we haven’t seen for many years, and the increase in U.S. rates has not been matched elsewhere in the advanced world. It’s not surprising that the dollar has risen against various baskets of currencies. Higher rates and a stronger dollar have two kinds of effects: They affect the real economy, and they affect asset markets. Obviously, these two interact.

Higher rates and a stronger dollar have two kinds of effects: They affect the real economy, and they affect asset markets.

Housing and auto sales slow

Housing and autos, the sectors of the economy that are most sensitive to movements in interest rates, have clearly turned down. No surprise here. As mortgage rates moved higher, housing affordability — or the combined effect of household income, house prices, and mortgage rates — has dipped. As evidence, the University of Michigan’s survey of consumers considers their outlook on economic prospects, including buying homes, cars, and other household durables. This outlook makes up the headline Consumer Sentiment Index. It is clear household attitudes have rolled over, and they have done so at the current level of interest rates and despite the strength of the labor market. At the same time, the labor market remains strong.

The pace of job creation continues to be robust, and unemployment is hovering near a 50-year low. But as we suggested in September 2018, real wages are not doing much at all, and there are signs the direction of the labor market may be changing. The Atlanta Fed’s “wage tracker” is a useful indicator of wage pressures because it avoids the composition issues that influence economy-wide average hourly earnings. It tracks the wages of the “same worker,” and the wages of people who switch jobs and those who stay in the same jobs. In a non-unionized labor market like the United States, a key factor driving wages is the “quit rate,” or the number of people who leave their jobs. As workers leave for higher paying jobs, their previous employers may face pressure to raise wages for existing employees to prevent further defections.

Real interest rates trend steadily higher 10-year real interest rates (%)

We track quit rates. Our findings indicate that in key sectors of the economy, a high and rising quit rate does not seem to be leading to much of a rise in wages. The Fed remains attached to the Phillips curve model (the theory that as the labor market continues to tighten, it will put upward pressure on wages and inflation). That could lead the Fed to favor continued interest-rate increases. But as the unemployment rate falls, the Fed is faced with risks becoming highly asymmetric. The Fed believes the economy is getting closer to a tipping point. This means policy has to take a hawkish tilt even though inflation is bumbling along at a perfectly reasonable rate.

Markets destabilized

Economic growth is expected to slow in 2019 as the stimulus provided by the 2017 tax cuts winds down. There is simply no sign of the kind of rise in private investment that would shift the economy to a sustainably stronger path. The outlook, therefore, is for the economy to weaken a little. The movements in real interest rates have destabilized equity markets. Real rates have moved up in two bursts this year. Rising rates at the start of 2018 caused equity market stresses in late January and early February, and markets tumbled in October after the Fed raised rates in September. The equity market matters for the U.S. economic outlook; wealth effects can be seen in household consumption, and the equity market has a large influence on the cost of capital for the corporate sector. A weaker equity market would mean weaker economic performance.

While we are not great enthusiasts for “financial conditions indices,” interest rates, exchange rates, and equity markets together can edge an economic forecast up or down. It’s hard to argue that a certain percentage change in equities is equivalent to a certain number of basis points of Fed hikes, or a certain change in the value of the dollar. Still, that idea makes some sense: If rates increase, the dollar would appreciate, equity markets would tumble, and the economic outlook would deteriorate. The bigger these changes, the larger the economic impact. How could it be otherwise?

Rising mortgage rates have affected home affordability (Housing Affordability Index)

There are signs the Fed is paying more attention to financial markets. Fed officials have made comments about leveraged loans, commercial real estate, equities, and financial stability. The argument goes that, if the Fed missed something in the 2004 to 2007 period, it was the growth of leverage and risk taking in the financial system, with the Fed too focused on more benign traditional economic indicators. Back then the Fed strongly argued that monetary policy should not be used to address asset market developments. That view has clearly changed.

The Fed ignored equity market stresses

The Fed was not worried about the recent equity market stress. Typically interest rates decline when stocks tumble. That didn’t quite happen during the October market sell-off. Despite the decline, the Fed continued its balance sheet reduction, effectively withdrawing liquidity from the market. It would have been easy for the Fed to ease up for a few days as equities declined, but they did not. Combine this with the increase in Treasury issuance as the deficit widens, and it looks more and more to us as though “excess” reserves have gone from the system.

The increase in interest rates is already producing effects in the real economy and in the markets for risky assets. These are happening at the same time as the global economy weakens and the outlook for inflation remains benign. What should a forward-looking central bank be doing in this context? Should it be banging on about how great the economy is and how rates might need to be pushed above neutral? Or should it be saying, let’s wait and see how all this plays out? The widely expected December hike doesn’t quite matter in this context. The issue is the 2019 outlook and what messages the Fed chooses to send about the next phase in monetary policy. A pause to wait and see? Or a signal that continued increases are warranted by fears of a tipping point in the labor market? The latter would be a mistake.

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Global economic growth remains vulnerable in the face of escalating trade tensions, higher interest rates, and volatility among emerging markets.