The US Federal Reserve surprised the markets when they failed to indicate a pause in monetary tightening at their policy meeting in December. In retrospect, that was probably a mistake, and the chairman Jay Powell has now responded to severe market pressure by indicating that the Federal Open Market Committee may pause further tightening.
Since the December meeting, markets had been indicating that the Fed’s probable policy stance in 2019 would be “too tight” to deliver on the central bank’s mandate of maximum employment with price stability, defined as 2 per cent inflation. On this interpretation, the Fed had made an error by tightening too much.
Annoyingly for believers in rational economic analysis, President Donald Trump’s critical tweets about Fed policy were not entirely wrong about that, and on Friday Mr Powell implicitly admitted as much.
Two shocks hit the US and global markets towards the end of 2018. The first was a contractionary demand shock from China, confirmed by the recent sharp declines in nowcasts for that economy; this led to downgrades in global activity forecasts, with a drop in US business surveys and inflation data. The second was that the Fed largely ignored these developments, leaving its policy guidance basically unchanged in December.
The key result of these two shocks has been a major downgrade in the market’s view of inflation risks over the relevant horizon for monetary policy (see section below).
There has also been a large rise in real bond yields. Higher real rates, with lower inflation, indicate that the markets were pricing tighter monetary policy than is needed to hit the inflation target. Jay Powell hints Fed open to pause
As Mr Powell said on Friday, this episode is quite similar to market behaviour after December 2015, when the Fed raised interest rates for the first time in the current hiking cycle, despite weakness in both the US and Chinese economies.
Markets certainly did not welcome that rate increase, and financial conditions tightened markedly. By the beginning of February 2016, the severity of market turbulence made the Fed’s position untenable. The key change came on 3 February, when Bill Dudley, then president of the New York Fed, said that the tightening had become so extensive that it would inevitably have damaging effects on the US economy.
Real bond yields quickly subsided while inflation expectations bounced back. With fears of deflation abating, asset prices embarked on a two-year extension of their great bull run. Mr Powell has been reluctant to adjust policy this time. This is because there are some important differences between early 2016 and the present situation.
This final reason has probably made the Fed staff much less willing to support a dovish move than they were when there was plenty of slack left in the economy. I believe that the staff may have less empathy with Mr Powell, a lawyer, than with the formally trained economists that preceded him, and may have been worried that he would cave in too readily to pressures from the president to ease policy.
In fact, the staff may have been working overtime to persuade the chairman to slow an economy that they fear is overheating substantially. This could have created a bias towards tighter policy than Mr Powell might have preferred. On Friday, he was more his own man.
There are two ways this episode could end. A good conclusion would be reached if US growth remains firm, which remains Mr Powell’s central expectation. The markets would then eventually accept that the central bank is right about growth, inflation and the need for “appropriate” rises in policy rates.
A less happy alternative is that market turbulence continues, and contributes to a further weakening in growth and inflation projections. On this scenario, Jay Powell will have to follow the example of Janet Yellen in 2016, and almost completely remove the bias towards additional tightening that existed in the Fed’s December policy guidance.
He took a large step, though not the whole way, towards acknowledging that on Friday. The markets will take note.
US inflation has surprised on the low side in the second half of 2018, but the FOMC has cut its inflation forecasts only slightly for the coming year:
Inflation expectations in the financial markets (eg break-even inflation in the TIPs, or inflation-indexed bonds, market) have dropped substantially as the economy has slowed:
However, with the FOMC continuing to suggest that it remains on course to raise policy rates this year, real interest rates have continued to rise:
The decline in inflation expectations, combined with unchanged real rates, is a signal that the markets believe a monetary tightening shock has occurred. Markets think that monetary policy has been tighter than it should be, but that should correct after Jay Powell’s latest remarks.