This is part I of a commentary titled ‘Should Financial Markets Celebrate Powell’s Pivot?’ from our macroeconomist Bob Gay
At his press conference following the FOMC meeting of January 29-30, Fed Chairman Powell expressed the Board’s decision to be ‘patient’ in implementing future adjustments to its policy rate. The media immediately dubbed his statement as a ‘pivot’ away from the forced march toward policy normalisation over the past two years that steadily had raised the funds rate and had begun to shrink the Fed’s bloated balance sheet. Financial markets rejoiced with significant rallies in equities, long-dated bonds and risk assets in general. To be sure, the Fed is taking its foot off the brakes and is willing to wait and see on how the economy fares in the months ahead. The question that comes to mind, of course, is why has the Fed set a new course? Do they know something we do not?
The Asynchronous US Economy. To be fair, there have been many red flags in recent months that signal economic and financial stresses around the globe. Credit spreads have widened appreciably towards the end of 2018; global trade flows have been disrupted by US tariffs and smouldering trade wars; and Brexit negotiations have created uncertainty in Europe. Emerging economies in general, and China in particular, have reported slower growth. Commodity prices have declined, and financial markets have been volatile. Yet none of these developments deterred the Fed from a rate hike in December, in large part because the US economy was still ‘strong’, and inflation was stable at the Fed’s long-term target of 2%. The other shoe seemed destined to drop on America, yet US employers continued to hire prolifically in January.
So why the change of heart? First and foremost, monetary conditions are much closer to ‘neutral’ now that the fed funds rate is back close to 2.5%. According to the December projections of FOMC members, the central tendency of the policy rate is 2.5% to 3% in the longer run, which is tantamount to the Board’s view of the nominal neutral rate. In short, FOMC members now consider the ‘new neutral’ for the real rate to be about zero to ½%. With the December rate hike, monetary policy was within that range and importantly no longer could be characterised as financial repression on savers. Note that the lower end of that range at 2.5% had been marked down from 2.8% in the September projections, thus opening the door to a pause.