By Howard Schneider and Jonathan Spicer
WASHINGTON (Reuters) - The Federal Reserve's plan to raise interest rates this year, forged over months of strong jobs growth and a seemingly durable expansion, now faces an economy that no longer follows the script and may push the "liftoff" far into the future.
The world's largest economy slowed to a crawl in the first quarter and may actually have contracted.
That was initially dismissed as a winter lull, but recent data may point to a more substantial slowdown just as the Fed plots its exit from a zero interest rate policy maintained since Dec. 2008.
Lackluster retail sales and investment, sagging consumer confidence, a ballooning trade deficit and stagnant industrial output have all cast doubt over the central bank's plans.
"The Fed has been telling us for some time that they want to be data dependent, and the numbers are nothing to run up the flagpole," said Conference Board economist Kenneth Goldstein.
The Conference Board is one of three organizations in a Reuters poll of economists that see liftoff in 2016, compared to 50 of 62 that expect the first rate rise in the third quarter of this year.
For traders, the weakened 2015 has complicated any guess at the Fed's direction. Treasury yields will probably fall if it becomes clear the central bank has to once again delay its plans, but that raises the risk of steeper and faster rate hikes down the road.
"The penance for a delay of the hike is a much steeper hike...That's the balance the market's been playing with," said Aaron Kohli, an interest rate strategist with BNP Paribas (PARIS:BNPP) in New York. "The longer the Fed stays on hold, the more risk there is that factors like inflation will build up."
CRUNCH TIME
The next few weeks will be key, heading into a June 16-17 Fed meeting when policymakers update their official forecasts.
Fed Chair Janet Yellen speaks about the economy on Friday and investors will look for either confirmation that she believes things remain on track, or a nod to the latest poor data.
So far, most policymakers have stuck to the mantra that the Fed will watch incoming data and assess "meeting by meeting" whether to raise rates, and have telegraphed September as a likely date for the first increase.
One of the few to advocate keeping monetary policy loose or longer, Chicago Fed president Charles Evans took his argument a step further on Monday. Not only should the Fed wait until at least early next year to raise rates, he said, but it should set a more aggressive standard on inflation.
"The odds should favor modestly overshooting our 2 percent target," before rates are increased, Evans said in Stockholm.
But he also acknowledged the fork in the road the Fed faces. A rate rise will be on the table beginning in June, and a surge in economic performance - housing starts and permits rose sharply in April as spring weather set in - could still cause the Fed to move faster.
"If the Fed's going to wait, they are going to make a bigger policy mistake," said Guy Haselmann, head of U.S. interest rate strategy at the Bank of Nova Scotia in New York. "They could miss the business cycle, in which case they get put on hold even longer, and they create bigger asset bubbles."
In a recent interview, San Francisco Fed President John Williams, who is seen to be close to Yellen's thinking, said that even if the economy were soft, it may be time to raise rates if only so future increases can proceed more slowly.
Williams said that if the economy continues progressing as he expects, and "Say I wait one meeting longer, two meetings longer...If I then decide to raise rates, I'm going to say ‘uh oh I am behind the curve,' I've got to get going, I am going to have to move faster."
Recent central bank research even suggests that the grim first quarter numbers are more a result of how the economy is measured and less a sign of true weakness.
CONSENSUS SLOW TO MOVE
For the majority of economists expecting a September hike, continued job growth means that at some point the country will reach full employment and wages and prices will rise.
"Conditions certainly don't feel overly robust," right now, said Carl Tannenbaum, chief economist at Northern Trust (NASDAQ:NTRS) in Chicago and a former Fed official. But "if we continue to see job creation of 200,000-250,000 per month...the Fed, under their mandate, would think it would be a good time to start the process," of raising rates.
The Fed last raised interest rates in 2006, at the tail end of a tightening cycle that had begun on a textbook note with market expectations closely aligned with the Fed.
Conditions this time are more treacherous.
Japan and Europe continue battling a risk of deflation with aggressive quantitative easing, while larger developing nations are slowing or fighting a mix of local problems.
Organizations such as the International Monetary Fund have warned of a risk of financial volatility once the Fed begins "diverging" towards higher rates. The recent rise in Treasury yields showed markets on a knife edge: some $3.2 billion was pulled out of seven top emerging markets in the first half of May, according to data released on Tuesday by the Institute of International Finance.
For investors, all of that points against a rate hike anytime soon. Markets in Fed Funds futures show investors have pushed back their expectations and are now divided between December and January as the date of liftoff.
"People gave the first quarter a pass because there was so much bad weather across main population centers, and things would rebound," said Brian Reynolds, chief market strategist at Rosenblatt Securities in New York. "That does not seem to be happening."