The Fed is on the Sidelines and it Could be Bumpy Ahead

The Committee sought to convey three sort of mutually exclusive things today:

1. The mid-course adjustment was done and markets should not anticipate further rate cuts unless there were additional signs of economic weakness.
2. In part because of the cuts in rates already delivered, the economy was going to perform well.
3. The FOMC was not on the sidelines.

The first point was important so that the Committee did not get locked into having to ease again in December.  I suspect that many participants had already been pulled along for one or two more cuts than they had initially signed up for and wanted some certainty that it would not happen again.  When the Committee is split, the policy action and statement often point in different directions (a policy easing and slightly hawkish statement, for example) reflecting a compromise struck to get agreement.

The second point was important because the Committee wants to increase, not decrease, business and household confidence.  It was for this reason, for example, that the FOMC changed its forward guidance in September 2012 from “…economic conditions are likely to warrant [a funds rate near zero] at least through…” to “…will remain appropriate for a considerable time after the economic recovery strengthens.” (See Nelson (2012).)

The third point was important because the markets react poorly when they conclude the Fed is on the sidelines.  While I’ve observed this over the decades, I admit I haven’t really been able to prove it.  I think that market participants take comfort from the idea that the Fed will act as a stabilizer when they consider the possible market reactions to different potential economic developments.  When the Fed indicates that it is on the sidelines or on “automatic pilot” that stabilizer is removed, extrapolations become more extreme, and markets get skittish.

The difficulty of conveying those three messages is that if you aren’t going to ease unless there is additional bad news and you think the economy is going to do ok then you are pretty much saying you expect to be on the sidelines.

To convey this message, the Committee made a small adjustment to the statement.  In particular, it changed an indication that it would “act as appropriate” to that it would “assess the appropriate path.”

Chairman Powell went further in his press conference and stated that the target range for the federal funds rate was in a “good place” to achieve their desired policy outcomes and that there would have to be a “material change” in the outlook before they would change it.  He repeated the phrase “material change” several times, at times referring to his notes.  Clearly there was a Committee discussion about, and agreement on, the “material change” language.

I expect that once market participants digest the Chairman’s remarks they will conclude he pretty much said the Fed is on the sidelines.  For example, in 2017 the FOMC said it planned to continue balance sheet runoff unless there was a “material deterioration in the economic outlook.”  The market’s conclusion that the balance sheet reduction was therefore on automatic pilot contributed significantly (albeit illogically) to the selloff in 2018Q4.

As a result, I suspect that there could be increased market volatility going forward.  Of course, the beauty of predicting market volatility is that you always end up being right.

Comments and discussion welcome and please feel free to share.

Bill

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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.