Breaking up (with forward guidance) is hard to do

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On the surface, the outcome of the 18-19 December Federal Open Market Committee (FOMC) meeting and Fed Chairman Powell’s press conference was largely as expected. The FOMC raised the target range for the fed funds rate by 25bp, but a weaker external backdrop and tighter financial conditions led a number of policymakers to lower their projections for the future path of the policy rate.

Greater caution in Fed communications…

As a result, the median rate projection shifted lower by 25bp over the usual three-year horizon. In addition to the median projection of just 50bp of fed funds rate tightening next year, there were elements in the Fed’s communications that suggested greater caution around the near-term pace of policy tightening.

These included:

  • Slight mark-downs to the median FOMC participant’s projection for longer-run unemployment and the fed funds rate. These revisions imply somewhat looser labour market conditions and less distance to a neutral policy setting, relative to the September projections
  • Downward revision to the median projection for core inflation through 2021
  • Reference in the statement to the FOMC monitoring “global economic and financial developments”
  • Chairman Powell’s acknowledgement during the briefing that somewhat soft inflation readings allow the FOMC to be patient in raising rates, as well as his emphasis that policy may not need to move into restrictive territory.

…though markets take a different view

Despite the downshift in the projected rate path, market participants appeared to have focused on more hawkish elements of the FOMC’s communications. Risk markets reacted negatively and long-term Treasury yields declined. For example, investors had largely expected the FOMC to remove from the policy statement the last vestige of forward guidance, i.e. the reference to “further gradual increases” in the fed funds rate. Instead, the language was retained, though watered down.

Investors may have interpreted the retention of forward guidance as an indicator that the FOMC is inclined to raise rates again in March. When specifically asked whether the committee could slow the pace of future rate increases, Chairman Powell stressed that he will be looking to see if incoming data is in line with the committee’s forecasts, implying that such an outcome would lead to a policy rate increase before long.

Other aspects may also have been read by investors as hawkish. As was the case in November, the statement described economic activity and the labour market as “strong”, while in contrast, investors have increasingly focused on signs of moderation in growth as well as additional downside risks. Similarly, Powell certainly mentioned ‘crosscurrents’ such as the global growth backdrop and tighter financial conditions, but was also quick to point out that these developments, “have not fundamentally altered the outlook.”

Balance sheet run-off: Powell says the effects are small

Another hawkish element involves the approach to the Fed’s balance sheet run-off. Powell was asked whether there were any concerns among the participants that run-off was having an adverse impact on markets, including credit markets. He remained faithful to the script that the effects of run-off are small, and “not creating significant problems” in money markets.

However, these comments are increasingly out of line with the view of many market participants that run-off is impacting financial conditions, in part through a widening of credit spreads.

What is surprising about the communications about the balance sheet is the lack of flexibility in approach. The chairman and other committee participants have shown commendable flexibility in their thinking about the longer-run unemployment and policy rates. They have also highlighted uncertainty not only about these longer-run variables, but also about their economic projections. Powell noted that he will keep an open mind regarding the possible implementation of the counter-cyclical capital buffer for financial institutions.

In contrast to such flexible thinking, the approach to balance sheet run-off is striking in its rigidity. If downside risks to the outlook grow, the insistence that run-off has little impact on financial conditions and can remain on autopilot will look increasingly at odds with any further downward revisions to the policy rate path.


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Steven Friedman

Senior Economist

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