About the Fed’s Great Monetary Pivot

Investors were pleased about the Federal Reserve’s latest policy announcement — perhaps a touch more so than Chair Jerome Powell and his colleagues might wish.

The central bank left its policy rate unchanged (at 5.25% to 5.5%) but the economic projections accompanying its new statement suggested a slightly faster pace of cuts next year than the Fed had previously indicated. A stock market that was already generously priced leaped higher on the news and longer-term interest rates declined.

Why should this reaction be anything but good news for the Fed? The central bank’s policy judgment is that short-term rates need to stay high a little longer to provide the appropriate degree of financial tightening and keep reducing inflation. In effect, this judgment was then partly undone by investors’ response — because higher stock prices and lower long-term rates make financial conditions looser and add to demand.

It was ever thus: There’s precious little the Fed can do about the determination of financial markets to second-guess, misunderstand, and sometimes outright reverse its policy decisions. The best Powell and his colleagues can do is be clear about the uncertainties, the limits of their power to steer the economy, and their commitment to get inflation back down to 2%. On these measures, given their current methods of communicating, it’s hard to fault their recent performance.

The Fed was slow to raise interest rates as inflation first spiked due to the pandemic, but once it began to tighten policy it moved more firmly than other central banks. Even though it had to lean against excessively loose fiscal policy, its tightening gradually brought inflation down from 9.1% at its peak to 3.1% in the year to November. To its own surprise, and almost everybody else’s, the Fed has achieved this without inducing a recession. The labor market is now cooling, but not so abruptly as to cause higher unemployment. So far, so good: The economy remains on track for the hoped-for soft landing.

Powell’s statements have also been well-judged — even if investors don’t always pay close attention. This week’s celebrations were driven, it seems, less by the chairman’s comments than by the so-called dot plot of future interest rates included in the Fed’s periodic summary of economic projections. The new dot plot suggests three quarter-point cuts in 2024, bringing the policy rate to 4.6% by year’s end, as compared with just two cuts in the September projections. However, as Powell made plain (for the umpteenth time) these projections aren’t a collective forecast, plan or commitment — merely an average of policymakers’ widely divergent views of what might be right if things turn out as each of them supposes. The chairman reiterated that “ongoing progress toward our 2% inflation objective is not assured. We are prepared to tighten policy further if appropriate.”

It's a pity, though hardly surprising, that many greeted the dot plot as affirming the opposite, as though it signaled the intention to raise rates no higher. With luck, the policy rate will indeed continue to fall as inflation subsides – but the response to the dot plot actually makes this benign outcome, other things equal, less likely, because it offsets some of the Fed’s tightening. In the same way, if investors commit too heavily to the soft-landing scenario, any subsequent need to boost rates will come as a shock that risks greater financial instability and a much bumpier ride.

Powell couldn’t have been any clearer about his priorities, unavoidable uncertainties and the Fed’s determination to get inflation — gradually but definitively — back to 2%. Yet he and his colleagues might ask themselves whether the dot plot is helping or hindering their efforts to be understood.