Fed to Markets: Economy is Solid, Rates on Hold

The Fed is out of the picture through at least the first half of this year as central bankers work to understand the path of economic activity going forward. Of course, we will all be doing the same. As it currently stands, there is a widespread expectation that grow slows in 2019. The ultimate degree of slowing, however, remains the key question. Enough to keep the Fed from thinking they need to snug up policy a little tighter? Or enough to prompt a rate cut? Still unknown, but with inflation failing to live up to expectations it does seem that the Fed has a fairly high bar to a rate hike and a low bar to a cut.

In general, policymakers remain upbeat on the economy. Federal Reserve Chairman Jerome Powell views the economy as in a “good place” with both low unemployment and low inflation. St. Louis Federal Reserve President James Bullard believes the Fed is now set up for “very good couple of years.” Dallas Federal Reserve President Robert Kaplan said he believes:

…it would be prudent for the Fed to exercise patience and refrain from taking further action on the federal funds rate until the economic outlook becomes somewhat clearer. I expect we will get some further clarity during the first half of 2019…the Fed has the luxury of being patient over the next several months.

Vice Chair Randal Quarles also sees the outlook and solid, and notes that he will be closely watching global risks over the “next six months.” Cleveland Federal Reserve President Loretta Mester thinks that monetary policy is just about right and “does not appear to be far behind or far ahead of the curve.” Still, Mester remains a tad hawkish and expects rates to move a bit higher if her forecast holds.

The takeaway is that the Fed is sending a very coordinated message that they are on hold through the first half of the year. Now that policy rates are near the estimates of neutral while inflation remains unexpectedly low, central bankers are content to slow down and review their handiwork.There is no pressing reason to raise rates given the external threats of slowing growth, Brexit, and trade policy challenges and the internal threats of Trumpian policy uncertainty, fading fiscal stimulus, and impact of past interest rate hikes. Better to sit back and wait to see how it all plays out before taking further action.

To be sure, the past few months feel very much like the late-2015, early-2016 period. In December of 2015 the Fed pushed forward with the first rate hike of the cycle despite lack of inflation, turbulent financial markets, and slowing growth. Ultimately, the decision to hike rates at that point appeared more model dependent than data dependent. The December 2018 rate hike had the same feel. But in 2016 the Fed was forced to accept reality and, like now, pushed by the incoming inflation to quickly put additional rate hikes on hold.

Like then, the decision to sharply shift gears could be key factor is sustaining this expansion. I have said that the December 2018 rate hike was an error, but a recoverable error. The Fed’s dovish shift reinforces my view that the error is likely recoverable. Like 2015-2016, fears of recession are growing. Paul Krugman frets about recession in this interview with Bloomberg. I agree with Krugman on this point:

The headwinds facing the economy prompted the Federal Reserve this month to halt its interest-rate hiking cycle, which Krugman said was never “grounded in the data” to begin with. “Continuing to raise rates was really looking like a bad idea,” he added.

Krugman sees “better than even” odds of a recession in the next two year, saying that “[t]here seems to be an accumulation of smaller problems and the underlying backdrop is that we have no good policy response.” Krugman notes that the Fed doesn’t have much room to cut rates and he doubts that the White House has the leadership capacity to mount a fiscal crisis.

On the second point, I agree that the leadership is lacking. That said, I suspect that Trump and the Republicans would have a huge incentive to use fiscal policy to prevent a 2020 recession.

On the first point, yes, the Fed lacks the normal degree of maneuverability in its interest rate tool to respond to a full-blown recession. What I think is forgotten is that the Fed has now 225 basis points of room to prevent a recession, and that is not trivial. The Fed responded to the Asian Financial Crisis with 75bp. It also responded to the 1995 slowdown with 75bp. The key is a willingness to act before a recession gets underway, and low inflation creates a willingness to act.

Separately, San Francisco Federal Reserve President said that discussions were underway use the balance sheet as a more regular policy tool. Via Bloomberg:

“You could imagine executing policy with your interest rate as your primary tool, and the balance sheet as a secondary tool, but one that you would use more readily,” Daly said. “That’s not decided yet.”

This compares to the most recent statement on policy normalization:

The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

The normalization statement implies that as of now, the expectation is that the balance sheet is a tool to be used when interest rate policy is by itself not enough to ease financial conditions. Presumably, that would occur when the economy has returned to the zero-lower bound. Daly offers up the possibility that the balance sheet could be used on a more regular basis.

Daly’s statements open a number of questions, the first of which jumps to mind is that if this is true, then is the current reduction of the balance sheet contractionary as many market participants believe? Is it really neutral as the Fed believes when Daly is signaling that the balance sheet could be used as a secondary tool? If that’s the case, then the Fed believes they are indeed still reducing financial accommodation by reducing the balance sheet, but just want you to believe something else.

My next question is what would be the objective of using the balance sheet? To influence the slope of the yield curve while pegging the near end? Does that mean regularly altering the mix of assets to influence the yield curve? Couldn’t this be done via signaling about the path of interest rates? Is the balance sheet about target specific aspects of the money markets? What aspects? Why do this outside of a crisis?

More questions: What is the transmission mechanism from the balance sheet to the economy? Is this mechanism different in a boom? A bust? Does the Fed believe they can fine tune the economy via balance sheet manipulation? That seems to be a leap for me; it’s not clear they can fine tune the economy with rates.

You see the point. The genie is out of the bottle; quantitative easing is a thing and it is not going away. Using it as even a secondary tool outside of the zero bound, however, raises lots and lots of questions. Hence I would be wary about reading too much into these conversations just yet. Many details need to be worked out to bring quantitative easing into regular play outside of the zero-bound.

Bottom Line: With policy rates near neutral, low inflation, and questions swirling around the economic outlook, the Fed is content to take a pause through at least midyear before changing rate policy. If the Fed were to move before midyear, I suspect that it would only happen in response to negative news that forced a rate cut. I believe the likely willingness of the Fed to cut rates should the outlook sour limits the odds that they economy slips into a recession; I would be more worried if inflationary concerns kept the Fed focused on rate hikes. While we wait for new information on the path of rates, the Fed will be updating its balance sheet policy. The next step in the process will be a slowing of the balance sheet run off with the expectation that at some point the balance sheet hangs in the background during normal times and is manipulated only as needed to support rate policy. It might be too early to speculate on the use of the balance sheet as an active tool during normal times; lots of messy questions there.