Chief Investment Strategist and Chief Economist
June 20, 2019Posted InInvestment Strategy
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The Fed now seems to be changing its policy reaction function toward a more "protective" strategy with less concern for inflation.
The Federal Reserve left policy rates unchanged on Wednesday 19 June, made no immediate changes to its existing balance sheet reduction plans, but gave a clear nod to very strong expectations of future Fed easing steps embedded in markets.
The Fed described US job gains as solid and consumer spending picking up. However, with trade worries causing greater US business uncertainty and these issues likely to see important news developments by the next FOMC meeting, the Fed no longer describes itself as “patient.” Instead, it “will closely monitor” the implications of incoming information and “act appropriately.” In the Fed’s updated Summary of Economic Projections, this led 8 of 17 FOMC members (voting and non-voting) to expect at least one rate cut this year for the first time.
The dispersion of forecasts was unusually wide, with one policymaker still expecting a 2019 rate hike, and a slim majority expecting no changes or higher rates. The median Fed funds rate forecast among committee members showed a drop to a 2.1% in 2020, increasing again to 2.4% in 2021. This is emblematic of current, unpredictable drivers of the economic outlook, most clearly trade policy. Today’s meeting included Powell’s first formal dissent, with regional Fed President Bullard voting to immediately cut short-term rates by 25 basis points.
In his press conference, Fed Chairman Powell made an unusually clear case for greater accommodation, citing sustained shortfalls in hitting inflation targets and greater business uncertainty. Akin to ECB President Draghi’s comments yesterday, Powell said the Fed would “use our tools as appropriate to sustain this long expansion.” He noted that much has changed since the last FOMC meeting in terms of risks to the outlook, but acting swiftly is not a particularly pressing concern. When asked if a trade deal with China or others might change the outlook, Powell said that no one development would be decisive for Fed policy, but “trade developments and global growth are really on our mind.”
Powell was unusually “on message” today, making the case strongly for sustaining the present expansion above any other concerns. His comments on inflation were markedly different from his assessment in March, when he said below-target inflation was “transitory.” However, if a Powell gaffe isn’t today’s story, markets clearly are. August Fed funds futures contracts and other short-dated yields imply a 100% probability of 25 basis point rate cut at the end of July, with the possibility of a larger cut. If the Fed is simply going to ease monetary policy no matter what comes, this may be a non-issue for markets. If instead, developments change Fed views, markets will be subject to sharp revisions in expectations.
In the near-term for financial markets, an easier Fed is better than a tighter Fed, if all else is constant. For whatever reasons, the Fed now seems to be changing its policy reaction function toward a more “protective” strategy with less concern for inflation. This view has long underpinned our expectation for future US dollar depreciation over the medium to-long-term, and made us more bullish earlier in the year after the Fed changed course from a far tighter projected policy path.
The Fed’s long inflation fight is over. Yet setting market expectations for a highly activist US monetary policy, with rate cuts while the economy and asset prices remain at a high level, may make future crisis fighting more difficult. It may mean truly radical steps are needed at some point if Fed policy easing becomes pro-cyclical and de-stabilizing – see Flying just above the danger zone in Mid-Year Outlook 2019. The Fed has simply never been able to offset all real economic risks with monetary policy. It may create some complacency that it can do so at a time when it may look deceptively easy.