Fed On The Horns Of A Dilemma

Milton Ezrati

Chief Economist

Pity Federal Reserve Board (Fed) Chairman Jerome Powell and his colleagues. At their Open Market Committee (FOMC) meetings yesterday, they decided to hold rates at current levels for the time being. Their decision is consistent with past Fed behavior and only prudent, but committee members will get little credit. President Trump has put them in an impossible situation. By demanding rate cuts and criticizing inaction at the Fed, Trump has rendered suspect anything the Board now does. If Powell cuts rates, as he suggested he might sometime in the near future – whether because of a softening in the economy or concerns over the ill effects of trade wars – many will accuse him of simply bowing to White House pressure.  If, on the other hand, the Board, for the most legitimate of reasons, sees no need for a rate cut, others will characterize it as risking the economy in a stubborn power contest with the president. The environment needlessly complicates policymaking.

So far, Powell seems to have played things straight. When in February last year he took over for Janet Yellen, the Fed had pretty much completed what monetary policy makers occasionally referred to as “normalization” of interest rates and policy generally. The Fed had ceased its quantitative easing – direct purchases of treasury and mortgage debt that the Fed used to support markets and the economy during the 2008-09 crisis and the disappointingly slow recovery that followed. Policy makers had even begun to sell off some of the purchases they had previously made. The Fed also sought to bring interest rates up from the near zero levels set during the crisis and disappointing recovery. It wanted to bring interest rates back into their historical relationship with the pace of inflation as well as with other economic indicators. Policy makers also wanted to get interest rates up to levels that would allow effective cuts should economic conditions demand it.  Powell has effectively extended this policy.

He made his first mention of a possible change this past June 4 when he announced that the Fed stood ready to sustain the expansion should the trade dispute with China threaten economic harm. Market participants saw in these remarks the promise of an interest rate cut. Bond yields fell in response and stock prices rose smartly. Some accused Powell of bowing to White House pressure.  But Powell neither promised nor bowed. Certainly, the calm way he refused to respond to earlier White House pressure stands as evidence that he was not now caving in. On the promise of rate cuts, he said no such thing. He made clear that all future Fed action will depend on the economic situation as it develops.

In itself, this decision to condition future policy on the flow of news does to a degree break with his predecessors. Less Janet Yellen and more her predecessor, Ben Bernanke, believed in telegraphing Fed policy moves. Bernanke claimed that it would help market participants prepare. Under him, the Fed would effectively forecast what the economy might need some months and quarters down the road and announce their policy intentions accordingly. Powell at the very least shows more humility. He knows that the Fed cannot forecast the economy any better than anyone else. Rather than say what will happen and how the central bank will react to it, he has simply said that the Fed will act if today’s concerns become reality.

There may be something else guiding the Fed’s current approach to policy. When the Fed makes a firm forecast, instead of a conditional one, it runs the risk that everyone in the market will set their trading positions on the basis of that forecast. Then, if conditions change and the Fed has to change its plans, all market participants together have to unwind their positions and assume new ones. That can cause considerable market disruption, even for a minor change in Fed policy. Especially since Powell is realistic about anyone’s ability to forecast, better that market participants have some doubt about policy’s next move. That way, different people will assume different positions, so that when circumstances demand a policy shift, only some market participants will have to change.

If the Fed is, in fact, adhering to such reasoning, it is well worth asking why Powell said anything early in June? He could have left the situation entirely ambiguous. After all, he has no idea of how the trade negotiations with China will go and a lot of uncertainty about how an agreement or the failure to reach one would affect the economy. What Powell and his team are likely concerned about is the effect of market worries themselves. The concern over the trade negotiations was creating negative psychology that if left unchecked could dissuade consumers from spending and more significantly impel firms to reconsider expansion plans, including hiring and capital spending. Worries about the future could then become a self-fulfilling prophecy. By announcing that the Fed, should it prove necessary, would act to counter the effects people fear, he has offered the economy protection against the development of too negative a psychology in the present, whatever else the future might demand of the Fed.

Increasingly, elements in the market see Powell’s promise as assurance of an interest rate cut. Certainly, should the Fed decide to act, it will come in the form of a rate cut, probably a small one at first. Even as the trade negotiations drag on, that decision will hinge on the flow of economic news. If history is any guide, the Fed will wait at least 2-3 months to get confirmation that economic conditions have changed. Since to date the economy has shown strength, an immediate rate cut at this month’s FOMC meeting was never likely. Even if things were to weaken suddenly in the next few weeks, a rate cut would likely wait until August or September. Policy makers will want to see if such bad news is a trend or just month-to-month volatility in the flow of information. Every month that the economy shows strength, especially if China and the United States arrive at a trade agreement, will delay the rate cut accordingly.

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