One of the major questions facing the Federal Reserve when its policy-making committee meets this week is whether to counter the recent big change in the way markets characterize its policy mindset. In the last few weeks, markets have come to believe that the central bank led by Chair Jerome Powell is behaving, and will continue to behave, much more like its two predecessors: averse to bouts of financial volatility, and willing to use words and actions to both counter and minimize them. This is a notable change from the earlier view that this new Fed leadership is focused on normalizing monetary policy as a means of creating greater policy flexibility to deal with a future economic downturn, while also reducing the probability of severe financial instability down the road.
Since the last Open-Market Committee meeting on Dec. 18-19, the U.S. economy has maintained a solid momentum, despite the longest partial government shutdown in history. The latest high frequency reports showed weekly jobless claims at 199,000, close to a 50-year low. That confirmed the signal from the more comprehensive monthly employment report for December: a solid labor market that continues to create new jobs at a pace well above expectations, is experiencing a pickup in wage growth, and is attracting discouraged job-seekers back to the workforce.
Despite the continued strong U.S. data, Fed officials have changed tune in their communications to markets in the last few weeks. And, in the absence of broad-based evidence of macro spillbacks to the domestic economy, the new caution does not appear related in a major way to the growing set of indicators that confirm the growth slowdown in Europe and China. Rather, it’s a reflection of what had been a sharp selloff in stocks, which was mainly a reaction to the Fed reiterating that its balance sheet policy approach would remain on “auto-pilot” despite greater uncertainty about the global economy. The shift increases the burden on the interest rate tool at a time when even small changes in discount rates can result in large differences in projections of asset valuations.
The Fed's subsequent change in the tone of its communication, known as policy guidance, led to a sharp multiweek recovery in risk assets that is making short investors scramble to cover their positions. Since the Dec. 24 low, the S&P 500 has bounced back almost 12 percent, the Dow almost 14 percent and the Nasdaq almost 16 percent. In the process, the Fed has illustrated again the power of consistent signaling from several officials (particularly the trio of the central bank's chairman and vice chairman, along with the president of the New York Fed, the most powerful of the 12 regional banks).
Now the Fed has to weigh again the balance between continuing to please markets and responding to continued domestic economic strength. On the one hand, it will wish to be cautious about reinforcing too much the notion of a full return to a “Fed put” that excessively decouples asset prices from fundamentals. On the other hand, it needs to refrain from again appearing to signal that it is not sufficiently sensitive to the risks to domestic economic activity of spillovers from weakness in the rest of the world and spillbacks from excessively volatile markets.
The best way to achieve this would be for the Fed to hint at greater policy flexibility than it signaled in December. Specifically, my expectation is that the central bank will use the statement and, especially, the press conference that follows the meeting to:
- Indicate that the next revision of the blue dots and economic projections will again likely be down;
- Point out that the balance of overall global economic risk has shifted more to the downside;
- Reiterate its inclination for patience when it comes to future interest rate hikes;
- Signal progress on the ongoing technical work on balance-sheet policy;