Sharp shift to Fed dovishness

Greater clarity from policy-makers would be helpful

The Federal Open Market Committee’s decision to pause rate increases was long telegraphed and widely expected. But the highly dovish messaging in the Federal Reserve statement and press conference by Chair Jerome Powell surprised markets. The reasoning for the sharp shift in Fed rhetoric between December and January remains elusive. Fed speakers will have an opportunity in coming weeks to shed greater light on the extent of the pivot.

The Fed is a hallowed US institution. The staff is uniformly excellent and first rate. The board is extraordinarily strong. Pause, patience, flexibility and data dependence had already appropriately become the Fed’s watchwords. The late January ‘pause’ was a done deal. But the board statement and press conference were perceived as going much further. The Fed’s tightening bias was dropped by removing language about the risks being roughly balanced and the indication that the next rate move could be just as well up or down. The Fed suggested its balance sheet will remain large and could be more proactively adjusted in the future.

Juxtaposed against this background, the FOMC statement reaffirmed its baseline economic outlook, noting sustained expansion of economic activity, strong labour market conditions and inflation near the symmetric 2% objective were the most probable outcomes. From the standpoint of the Fed’s dual mandate, labour markets are quite strong, but price pressures remain muted, providing ample space for a ‘pause’.

To reconcile an unchanged baseline view with highly dovish messages, the Fed pointed to increased downside risks.

Many of these are external – China, Europe and Brexit. China’s slowdown may be more severe than thought, but Beijing is injecting significant stimulus, which should help stabilise conditions. The European forecast has only been marked down a few tenths of a percentage point, and Brexit remains a longstanding, though still unfinished, saga.

The greater attention seemingly being paid by the Fed to global developments in recent years in its monetary policy reaction function is welcome. Nevertheless, given the still positive US baseline outlook, the relatively closed nature of the US economy and the modest markdowns in global growth, it is hard to see that the slightly weaker global economic outlook, absent associated financial stress or shock, provides sufficient rationale for the sharp change in rhetoric.

Uncertainties from President Donald Trump’s trade wars and protectionist rhetoric are another downside factor, but the mood around discussions with China has brightened. The US government shutdown was extraordinarily unwise, but its macroeconomic impact will be short-lived and recouped.

Volatility in financial markets and conditions could explain increased downside risks. Stock markets were hammered in December amid the president’s unwarranted attacks on the Fed, public rebukes of Chinese trade practices, and shutdown politics. But stocks had rebounded quite nicely by the time of the January FOMC meeting and yields (Treasury 10-year) had also come down to 2.7% from around 3.2% in November. Moreover, the fed funds rate in the Fed’s view still remains at the bottom of the neutral range. Overall US financial conditions are still not tight.

To add to the highly dovish message, the Fed indicated that it could adjust its path for balance sheet normalisation, and underlined that its balance sheet would remain large. As the end to balance sheet normalisation appears on the horizon, it will behove the Fed to provide greater clarity to markets. But it is not clear that time is currently approaching, as opposed to later in 2019. Further, a larger future Fed balance sheet, certainly in contrast with pre-2008 crisis days, was widely expected given bank demands for high quality liquid assets and the Fed’s need to control short-term interest rates. But here too, it is difficult to reconcile balance sheet normalisation as a factor contributing to financial market volatility, when new issuance emanating from the massive and unfortunate increase in the US fiscal deficit swamps the impact of normalisation.

On balance, the messaging at the end-January FOMC meeting was very dovish and stood in stark contrast to that in mid-December. The Fed stood behind its baseline US economic outlook. The downside risks it pointed to provide a firm basis for the ‘pause’ and more generally the shift towards ‘patience’, ‘flexibility’ and ‘data dependence’. But these risks together do not yet seemingly add up to an adequate explanation for the extent of the shift in the stance towards dovishness. Hopefully the Fed will in the coming weeks provide a more fulsome explanation for the sharpness of the shift.

Mark Sobel is US Chairman of OMFIF.

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