The Federal Reserve puts an end to normalization – My weekly column

The economic basis for the end to normalization is unclear as any number of interpretations are possible: the Fed is leaving investors in the dark. Perhaps this move marks the start of a less predictable policy doctrine to leave some scope to surprise investors: this type of approach was very frequently discussed in theoretical documents on monetary policy in the very distant past. It would mean that forward guidance no longer has the same significance that it had until very recently. In other words, monetary policy logic has changed, moving from a very clear policy that minimized risk to an approach where investors’ interpretation of the Fed’s moves will be key. This question still remains to be seen, but it looks like a radical change in strategy.

On the third chart, we can see a fairly clear relationship between tougher monetary policy and the chances of a recession. The three recessions identified on the chart are all preceded by tighter monetary policy. Is this still the case today? This question harks back to the previous point on the relationship between Fed Fund rates, monetary policy and economic activity. This is not what the Fed expects.

We can draw parallels between the current situation and the period of monetary policy normalization in 1994. At that time, the Fed had started to tighten policy (also on February 4!) to tackle a potential return to inflation, regain some leeway and make monetary policy more compatible with the economic cycle. However, we can see that this readjustment was completely unlike the current situation as real interest rates stood at around 4%.

So our hunt for an economic basis for the Fed’s decision leaves us empty-handed. The Fed remains optimistic on the US cycle but has eased its tone. This is a new context in the US and the rationale behind it is still unclear, unless we believe that the Fed has information that the public is unaware of, or that it is seeking to extend the cycle at any cost.
Meanwhile, ISM and job data for January do not point to the need to bring monetary policy normalization to a swift halt.

However, if we read the statement and listen to the press conference, we do come across one new aspect. The Fed does not attribute the end to normalization to domestic factors because the international environment is worrying, thereby creating risks that could affect the US economy. This argument has never been used so far. It is worth remembering that in 2016, Janet Yellen had delayed a rate hike due to tension and doubts over China, but it was merely a postponement. The decision announced on January 30, 2019 marks the end to normalization, which is a much more radical move and a very strange argument, as the US economy is fairly closed.

The chart opposite shows the extent to which some economies are open to outside influences.
The US economy is a large and closed economy, and it is not much more open to influence from outside factors today than it was 20 years ago. So using changes in the rest of the world as a justification for a shift in monetary policy is most definitely over the top. The Fed has always focused on domestic issues to develop its strategy, and based on the economy’s continued fairly closed profile, there is no reason to change its methods.  
We can also see on the chart that the question is very different in the euro area, which is very open to outside influences, particularly due to the German economy’s features. The area is much more exposed to influence from events in the rest of the world.

So the argument of uncertainties outside US borders is not entirely convincing. These concerns are admittedly real for all of us, whether American or not, and no-one can deny the potential impact of Brexit, the slowdown in China and US-China trade tension. However, the macroeconomic impact for the US is small given its relatively closed economy.

The Fed is putting the brakes on monetary policy normalization for reasons that look unwarranted when compared with the way it usually reacts. Its optimism on the economic situation contrasts with the end to rate hikes at a time when real rates are still well below 1% (real rates are set to rise as inflation falls, but not to an extent that would put them on a par with previous episodes). Justifications are not domestic but rather external, which is strange for a large and closed economy.

The motivations behind the Fed’s moves are often negative events on the financial markets, primarily the stock-markets. In the past, this explanation worked as it took action after a crisis moment in vital moves to swiftly reassure investors. This was the case during various events, first and foremost October 1987, and the Fed will do so again in the future.
But in this case, would the Fed really have watched the markets collapse in December and then make its move when the US market posted its best January performance in 30 years? This looks like an excessive explanation, even if Powell appeared increasingly dovish over recent weeks.

Let’s hope that the Fed does not need to hike key rates on economic justifications for any reason other than inflation. Powell has clearly mentioned the impact of falling oil prices on inflation and the leeway that created for monetary authorities. He also indicated that the central bank would only hike rates if inflation picked up, particularly as a result of oil prices, which looks unlikely this year.
So a rate hike would have a crippling impact on the Fed’s credibility, and it can only cut its leading rate if it wants to remain credible. The only way to hike rates and safeguard credibility at the same time would be if oil prices were to surge.

This prospect would mean a dollar that no longer has any upside, which would be good news for emergings, especially those with dollar-denominated debt.
This would also mean a future drop in long-term interest rates. According to the Fed, fears of a negative shock in the future would give an even greater advantage to low-risk assets, such as sovereign bonds. 10-year yields in the US, Germany, Japan and also France would continue to be pushed down, further exacerbated by the Fed’s balance sheet management policy, which will no longer be on autopilot, but rather would be used as a monetary policy instrument.

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