Is the Fed Ready to Change Course?
The Federal Reserve’s Open Market Committee is meeting this week in the context of a weaker data patch in which “hard” measures of economic activity continue to lag better sentiment indicators. As a result, the central bank is widely expected by markets to maintain an unchanged policy stance when the two-day meeting concludes on Wednesday.
Nevertheless, this will be an interesting test of the view, which I and some others have espoused, that the Fed is in the process of shifting operating regimes -- from following markets to being more willing to lead them.
Last week’s disappointing reading of 0.7 percent gross domestic product growth for the first quarter, the lowest in three years, added to other data releases (such as retail sales, inflation and autos) suggesting that the U.S. economy -- and consumption in particular -- is going through a softer economic patch. In previous years, this would have provided the Fed with the excuse to soften its policy signals, assuring markets that monetary policies will remain ultra-stimulative and minimizing the risk of financial asset volatility. Indeed, these are the signals that the European Central Bank reiterated last week when its governing council met. And the ECB did so despite official recognition that, in the case of the euro zone, economic conditions have improved and forward downside risk is lower.
The Fed’s inclination to repeat past practices is countered by three considerations.
- An element of the recent data weakness is likely to be both temporary and reversible.
- The Trump administration has reiterated its intention to pursue a large tax cut that, if approved by Congress (a big if), would most likely lead to a considerably wider budget deficit, at least in the short-run until economic growth and budgetary receipts pick up (especially given the lack of large revenue measures).
- Though even harder to quantify, the Fed is not indifferent to the collateral damage and unintended consequences of prolonged reliance on unconventional monetary policies.
Rather than soften its policy guidance, the central bank is likely to maintain its baseline projection of two additional rate hikes this year (for a total of three) and advance discussions on the normalization of its balance sheets (the final details of which, however, are unlikely to emerge from this meeting). In doing so, it will avoid a phenomenon that had occurred numerous times in the last few years: having its policy signals dragged down by markets that have been conditioned to expect even more lenient monetary conditions in the event of virtually any domestic or international headwind to economic activity.
This is not an easy position for the Fed to be in. If officials decide to maintain their policy guidance unchanged, they would risk tightening into an economic slowdown. But if they back away, they would risk reinforcing a market behavior that has already decoupled prices from fundamentals and distorted asset allocation in markets and the economy.
The best, indeed perhaps the only prospect for a “beautiful” normalization of monetary policy -- to adapt a term used in another context by Bridgewater’s Ray Dalio -- is for the Fed (and other central banks) to be able to transfer a large part of the macroeconomic policy burden -- which they have been carrying almost single-handedly -- to the institutions and officials that implement fiscal policy and structural reforms. The longer this handoff is delayed yet again, the greater the central banks’ policy dilemma and the larger the risk of a potential policy error.
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