Frozen 3

The forward guidance that the Fed is providing in the FOMC minutes is a curious mixture of promising not to tighten and promising not to ease.  The guidance could leave the Fed behind the curve in responding to the coming COVID-19 stock market crash, ultimately ending up at the zero lower bound.

After the October FOMC meeting, at which the FOMC executed its third consecutive 25 basis point, Chair Powell stated that it would take “a material reassessment of the economic outlook” for the Committee to cut further.   The Troika (currently the Chair, President of the New York Fed, and Vice Chair (Clarida)), the group that prepares the advance drafts of FOMC communication, often combine hawkish language with a dovish policy action, or vice versa, to maintain consensus across the Committee.  Even with the guidance, two Presidents George and Rosengren dissented, preferring to leave policy unchanged.  President Rosengren dissented in part because he was concerned that low rates could “further [inflate] risky assets”, a concern that was expressed by “a few” participants in the meeting (perhaps including two non-voters).

The “material reassessment” language seemed designed to prevent expectations for an additional cut to get built into markets over the upcoming intermeeting period.  Once such expectations start to build, unless they are pushed back, they force the hand of the Committee to ease.  Not easing when expected to do so would be tightening surprise, and the Committee is loathe to deliver a tightening surprise.  Knowing this, if the odds of easing toward the end of the intermeeting period are greater than 25 percent, roughly, and a testimony, speech, or well-placed news story doesn’t materialize to beat the odds back down, they will rise to near 100 percent by the time the meeting takes place.

With it established that the FOMC wasn’t cutting any more for a while, the Troika focused on placating those who wanted to cut (including, no doubt, at least one member of the Troika), largely out of concern that inflation was running too persistently below 2 percent.  The December minutes noted that “maintaining the current stance of monetary policy for a time” could help cushion the economy from negative global developments.  Note that the statement only makes sense if the Committee is explaining that it won’t be raising rates anytime soon.  There is similar language in the minutes to the January meeting.

In short, the Committee is now saying that it would take a lot to make it cut rates further, in part because doing so could lead to financial instability, and that it is not raising rates for a while either, in part because it needs to keep providing the current level of stimulus to support the economy given the unsettling news from abroad.  While the combination makes perfect sense, it could lead to an unwelcome outcome.

At some point soon, the stock market will drop significantly in reaction to COVID-19.  Normally, market participants would take mental comfort from the fact that the FOMC will ease rates if the situation deteriorated.  However, the Committee participants who supported the “material reassessment” language could argue that some decline in stock prices is warranted and moreover that the Fed needed to make it clear that they were not going to cut rates so that they didn’t end up being forced to cut to avoid making the situation even worse.

If, as it becomes clear that there will be no Powell-put, there is an even greater deterioration in financial conditions, those FOMC participants most concerned about the low-level of inflation, could convince the Committee to ease.  The Committee would want to take a forceful action to generate a positive market response.  If the Committee were to cut 50 basis points, leaving the bottom of its target range at only 100 basis points, it could determine that it should simply go all the way down to the zero lower bound.  “Keep your powder dry” is exactly the wrong policy as you approach the ZLB.

Sorry to be Debby Downer on this sunny day.  Maybe the Committee will cut aggressively now to get ahead of the pandemic.

As always, comments, discussion, and forwarding welcome, and please let me know if you would like for me to stop cluttering up your inbox with these emails.

Bill

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.