US recession risks are rising, so where does that leave the Federal Reserve?

David Absolon
Janet Yellen Addresses The Economic Club Of New York
The Fed is walking a tightrope (Source: Getty)

Since the Federal Reserve in the United States raised interest rates in December (albeit by a very modest 0.25 per cent), concerns have been mounting that the momentum of the US economy is fading, and that the US is in fact facing recession in 2016.

What is clear from recent data releases is that the industrial side of the economy, which includes energy-related activity, has been weak. However, consumption, including the housing sector and retail sales, has proved more robust.

Overall, the picture is certainly more uncertain than back in December, particularly as it concerns other major economies and regions, including China and Europe. So, the question must be asked: where does that leave the Federal Reserve (“the Fed”) as it considers how to adjust policy going forward?

Read more: Yellen - "We're taking a look" at negative interest rates

In her recent semi-annual testimony to congress, the Fed’s chair, Janet Yellen, acknowledged external risks had increased. However, she remained optimistic that US economic growth could be sustained by ongoing labour market improvements and the recovery in the housing sector, both of which would support domestic demand.

Despite the market pricing in no increase until mid-2017, she did not rule out an interest rate increase in March. Yellen did express more concern about the inflation outlook, however, which suggests that the Fed will be careful not to raise rates too aggressively.

There is much talk of a “policy mistake” by the Fed, that December’s increase was premature, and that another increase would compound the mistake. Our view is that a modest hike was justified at the time, justified by the improving labour market and stable core inflation.

Read more: Fed members concerned about slow inflation

Looking forward, the argument against further hikes at this point comes more from financial market volatility and the potential for further dollar strength, rather than because we see the US economy being quite as fragile as suggested.

For choice we think that the Fed would like to move rates higher, but is sensitive to the market effect, so at this point a March hike seems unlikely unless data releases in the coming weeks suggest that recent weakness is transitory.

The Fed is walking a tightrope between being seen to show confidence in the US economy and at the same time navigating the challenging global headwinds. The US economy is not yet in the doldrums. However, in recent years markets have relied too heavily on central banks and it seems time for governments to pull the fiscal lever and add support - not just in the US but elsewhere.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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