Federal Reserve’s ‘momentous’ U-turn prompts puzzlement

After putting traders on notice six weeks ago to expect further increases in US interest rates in 2019, the Federal Reserve on Wednesday executed one of its sharpest U-turns in recent memory.

Leaving rates unchanged at 2.25-2.5 per cent, Jay Powell, Fed chairman, unveiled new language that opened up the possibility that the next move could equally be down, instead of up. Forecasts from the Fed’s December meeting that another two rate rises are likely this year now appear to be history.

Changes to its guidance were needed, Mr Powell argued, because of “cross-currents” that had recently emerged. Among them were slower growth in China and Europe, trade tensions, the risk of a hard Brexit and the federal government shutdown. Financial conditions had also tightened, he added.

Yet the about-face left some Fed-watchers wrongfooted and bemused. Many of those hazards were already perfectly apparent in the central bank’s December meeting, when it lifted rates by a quarter point and kept in place language pointing to further “gradual” increases.

Meanwhile, the federal shutdown is over — at least for now — and the US economy is in a hearty state. The US labour market is continuing to power ahead, wage growth has picked up and financial markets are on a more even footing.

“It was a big change, and a surprising one,” said Roberto Perli of Cornerstone Macro, of the Fed’s new rates outlook. “The fact that a convincing justification was lacking is perplexing.”

Michael Feroli, US economist at JPMorgan Chase, said he could not remember such a big change of direction by the Fed absent a major shift in the economic backdrop, calling the adjustment between December and January “momentous”. One explanation could be that more dovish officials such as Richard Clarida, the Fed’s vice-chairman, were gaining sway over the decision-making process, he said.

Another is that the Fed is being swayed by market pressure. Michael Gapen of Barclays said it was difficult to read the outcome of the meeting as “anything other than the Fed capitulating to recent market volatility”.

Some of the guidance the Fed gave on its balance sheet policy added to that impression. The central bank has recently been deluged by complaints that its balance sheet reduction programme is destabilising markets — a notion that officials find dubious. Nevertheless, the Fed accompanied a new statement describing its preferred rate-setting framework with reassurances that it would adjust “any” of the details of the asset reduction plan if economic or financial conditions warrant it.

For his part, Mr Powell roundly rejected suggestions by reporters that there was now some sort of “Powell put” in which the Fed comes to the rescue when Wall Street is in a swoon. His only motivation, he added, was “to do the right thing for the economy and for the American people. That’s it.”

The Fed chairman also dismissed any notion that the central bank had altered the course of monetary policy in the face of presidential lobbying. President Donald Trump has made repeated public demands that the Fed stop lifting rates, but Mr Powell repeated past assurances that the Fed ignores such political considerations. “We’re human, we make mistakes, but we’re not going to make mistakes of character or integrity,” he said.

To be fair, Wednesday’s meeting was hardly the first time that jittery markets have convinced the US central bank to adjust its policy plans. In early 2016, for example, an outbreak of market volatility prompted the Fed, then led by Janet Yellen, to sharply trim back the number of rate increases it was considering. The so-called taper tantrum in 2013 under Ben Bernanke spurred the central bank to delay plans to slow its asset purchases.

But the Fed had a clear underlying strategy that remained in place during those episodes. To some analysts, the central bank now seems more adrift. Until recently, for example, the key argument behind the Fed’s tightening cycle was the idea that further declines in unemployment would stoke inflation pressures.

Yet that discussion was absent from Mr Powell’s press conference on Wednesday. Instead, he indicated he was going to be closely watching actual inflation data, among other indicators, in judging if more rate rises would ultimately be needed.

This raises the concern that the Fed could be overly influenced by short-term fluctuations in economic numbers, Mr Gapen at Barclays said. “Our main concern is that hyper-data dependence means a reactive Fed, potentially whipsawed by market movements and absent clear direction.”

It is not certain that the US has seen the final rate increase in the current cycle, but the bar to a further tightening now seems appreciably higher than it was. The Fed’s new dovish guidance undoubtedly comes as welcome news to global markets. But it has not dispelled concerns that there has been a trend towards uneven and unpredictable communications from the US central bank.