Bloomberg – There seems to be something for everybody in the minutes of the Jan. 29-30 meeting of the FOMC, the Federal Reserve’s policy-making committee. The transcript released Wednesday is, on a standalone basis, likely to keep financial markets relatively steady after the dizzying rollercoaster ride caused by overly hawkish miscommunication from the Fed that was followed in January by an overly dovish policy U-turn. But the latest minutes highlight the communication challenge the Fed faces amid fluid and divergent economic conditions in the systemically important countries. A test could come as early as the next FOMC meeting in March. Here’s why:
1.Of the four main factors that could have influenced the Fed policy reversal in January, the two domestic economic considerations – internal economic weakening and/or great optimism about remaining slack in the economy, along with an impending productivity pickup – do not appear to have been overwhelming or deterministic in driving the central bank’s decisions to be “patient” about the rate increases that were previously signaled and to show “flexibility” about what had been an auto-pilot approach to balance-sheet reduction. Indeed, while the minutes mention downside risks, it’s hard not to notice that Fed policy makers continued to strike an overall positive note regarding economic activity (“rising at a solid rate”), the labor market (“strong” job gains) and inflation (“near the Committee’s symmetric 2 percent objective”).
2. By contrast, the other two factors – concerns about deteriorating international economic conditions and the potential for spillback from the fourth quarter’s financial market disruption – seem to have captured an unusual amount of the FOMC’s attention. Officials pointed to China and Europe in particular; and some “emphasized the need to monitor financial market structures or practices,” which may have contributed to “strained liquidity conditions” a few months ago.
3.This stands in contrast to past tendencies when either domestic considerations dominated or when Fed officials were hesitant to highlight the two factors cited above lest they open themselves to criticism of trying to be “the world’s central bank” and/or being held hostage by markets.
4.Underlying all of this is the challenge of normalizing monetary policy in the context of fluid and divergent global economic conditions, not to mention the risks associated with trade tensions (referred to in the minutes as part of “a number of uncertainties, including those pertaining to the evolution of policies of the U.S. and foreign governments, still await[ing] resolution”). Recall that economic strength in the U.S. is offset by weakness internationally that is likely to intensify; and there is nothing to suggest that the right balance can be maintained globally. Also, companies in the major stock indices are much more externally exposed than the real economy as a whole. And none of the major countries are keen to see their currency appreciate, thwarting an important market-based adjustment mechanism.
5.With these factors in play, the Fed will feel compelled to be data dependent. Yet markets have already interpreted its January pivot as implying not only a rate pause all year and a cut in 2020 but also an early termination to balance sheet reduction. Many are inclined to expect that the next FOMC meeting, which will include the important periodic quantitative update (the “dot plot”) specifying individual central bankers’ point estimates, will show a flat, then declining, interest rate path over time. The FOMC meeting also is expected to provide detail on when and how policy makers will “stop reducing the Federal Reserve’s asset holdings later this year.” (As an aside, and further to my last post in which I discussed the desirability of replacing the dot plot with something more scenario-based, the minutes show that a few Fed officials already worry that “at times the public had misinterpreted the median or central tendency of those projections as representing the consensus view of the Committee or as suggesting that policy was on a preset course.”)
6.This makes the Fed’s communication challenge even more acute. The central bank has swung from excessive hawkishness — embodied in signaling and delivering four rate hikes in 2018 and in reasserting several times the balance sheet auto-pilot approach — to its latest appeal for patience and flexibility. Now policy makers will undoubtedly wish to stabilize expectations while, critically, reclaiming and retaining policy optionality. But any notable signal that disrupts the markets’ perception of an uber-dovish Fed could trigger financial volatility and raise concerns about a repeat of the fourth quarter’s disorderly markets. The Fed will hope that a series of upcoming appearances by policy makers, together with intervening data (including the monthly jobs report for February), will help reduce the risk of another communication failure involving the central bank and markets. If not, it wouldn’t come as a huge surprise if the Fed decided to let the markets’ interpretation run for a while lest attempts at moderating it end up by causing renewed and potentially disruptive financial instability.