31 January 2019
At its January meeting, the US Federal Reserve (the Fed) kept its benchmark interest rate unchanged, in line with expectations, but the overall tone of the statement surprised on the dovish side. This was a pretty remarkable shift, and likely an unnecessary one, as not much has changed over the past few weeks in terms of the economic outlook.
In its assessment of economic conditions, the Fed did not make any significant changes, characterising growth as ‘solid’ and the job market as ‘strong’. However, its assessment of risks has changed significantly. Powell emphasised several cross-currents that suggest a less favourable outlook, including a continuing slowdown in global growth, a range of political risks such as Brexit, trade uncertainty and the US government shutdown, as well as less supportive financial conditions. He also noted muted inflationary pressures, suggesting the risk of higher inflation has diminished.
More remarkably, policy guidance on interest rates and balance sheet normalisation has shifted entirely towards the dovish end of the spectrum, with ‘adjustments’ to the target range for the federal funds rate replacing ‘increases’, which puts interest rate cuts back on the table. Adjusting the pace of balance sheet normalisation and the ultimate size of the balance is now an option too, which the Fed has chosen to put in the picture much earlier than expected.
'Bad is good’ mindset
However, the economic outlook does not appear to warrant the Fed’s new tone. The US government shutdown was a transitory event for the Fed’s purposes. Meanwhile, the external environment is somewhat weaker but not dramatically so, with the balance of risks around such factors as Brexit and trade essentially unchanged. Financial conditions are actually easier since the last meeting, not tighter. This is clearly supportive of risk for the time being, with markets happy about ‘the Powell put’.
I believe this shift will come to haunt the Fed later in the year when the economic backdrop will most likely necessitate more hikes, not cuts. Greater clarity on the economic cycle will only emerge toward the middle of the year, though. In the meantime, distortions will bias data to the downside, putting markets back into a ‘bad is good’ mindset. With press conferences now following each FOMC meeting, Powell will have a few more chances to become a hawk again.
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