A pivot of the Fed, born of volatility, errors and the new economic reality

WASHINGTON (Reuters) – The Federal Reserve's January pledge of "patience" in the face of further interest rate hikes, putting a three-year policy tightening process on hold, has been put on hold. Calmed markets after weeks of turbulence that wiped out billions of dollars of wealth households.

Interviews with more than half a dozen policymakers and others close to the process also suggest that this was a more fundamental shift that could shape President Jerome Powell's mandate as the point where the Fed for the first time fully embraced a world characterized by stubbornly low inflation, ever-slower growth and sustained growth. permanent reduction of interest rates.

In addition to Powell's public comments, the Fed's minutes and other documents, we see the image of a central bank moving toward a potentially difficult period of change as it examines how to do business with the bank. light of this new reality. One question, for example, is whether crisis management policies should be part of routine tools. Another question is to know if one should try to prepare the public to accept higher inflation from time to time.

Policymakers have been discussing for years the adequacy of the traditional central bank to a world transformed by the global financial crisis of ten years ago. But it was Powell's brief remark on October 3 that triggered the chain of events that helped solve the problem.

"We are far from being neutral now, probably," Powell said at a Washington think tank meeting, citing a level of interest rates that neither cools nor boosts. 39; economy.

Although Powell effectively summarizes what the Fed just concluded at its political meeting on September 25-26, when it raised rates while US growth was stronger than expected, its description touched a nerve.

Investors have dumped stocks and bonds, fearing the Fed will lead to higher rates than the economy could handle.

These are the beginning of weeks of volatility that led the Fed to recalibrate its message, with more than one misstep along the way.

In doing so, the central bank has done more than fine-tune its wording or adapt to changing conditions. Interviews with officials, as well as analysis of the Fed's minutes and public statements from policy makers suggest the emergence of a long-standing indefinable consensus that interest would probably not come back to pre-crisis levels and that an established relationship, such as increasing inflation when unemployment was falling, was no longer working.

The concern over the Fed's debates over years of strong economic growth and falling unemployment, which would inevitably have the effect of boosting inflation or threatening financial stability, has largely disappeared since Fed meeting on Dec. 18-19, according to a report of Fed meetings and officials. & # 39; public statements.

GRAPHIC – How the Minutes of Fed Meetings Reflected Changing Perspectives on Interest Rates: tmsnrt.rs/2TX9fC0

It was a hidden conclusion to everyone's sight. After a year in which the Trump administration reportedly injected about $ 1.5 trillion in tax cuts and public spending into a full – employment economy, the Fed would still reach its goal of spending $ 1.5 billion. inflation of 2%.

"I hate to say we were right," Dallas Federal Reserve Chairman Robert Kaplan told reporters on January 15 in Dallas. "But we warn for some time now that … the structure of the economy has changed dramatically."

Technological innovation, globalization and the Fed's commitment to meeting its inflation target have all kept prices down, and "these forces are powerful and they are accelerating," he said.

His arguments echoed those of St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari. New Fed Vice President Richard Clarida and Governor Lael Brainard have reported similar issues.

Later in January, the Fed's policy moved away from further rate hikes and cited "moderate inflation" as one of the reasons, largely aligning the Fed with the sentiment among investors who saw conditions weaken.

At first it was in early October that investors appeared to have overreacted to Powell's remark about the "long road to neutrality".

Global markets absorbed nearly two years of quarterly rate hikes from the Fed, but 10-year Treasury yields climbed by one-tenth of a point that day and equities began to fall. cleared 10% of the value of the S & P 500 index at the end of November. .

If it was maintained, it was the type of environment, with declining asset values ​​and tighter borrowing conditions, that could hurt the Main Street economy, not just the category of investors.

Powell and other Fed officials first responded that the US economy remained strong and that it was not up to the central bank to pamper Wall Street.

"We are watching the markets very carefully," Powell said at an event in mid-November in Dallas. "But it's one of many factors that go into a very big economy."

But investors were not just reacting to the Fed and the prospect of rising rates. The weakening of business and consumer confidence, the slowdown in global growth and the potential disruption of the trade war between President Donald Trump and China were also taken into account.

In the weeks that followed, the Fed tried to incorporate these concerns into its policy, but it became clear that the situation was more fragile than what they had imagined.

At the beginning of December, part of the bond yield curve was "reversed", with short-term rates exceeding long-term rates, which can be considered a loss of confidence in economic growth.

For months, Fed officials have debated the opportunity to ignore developments such as the shock of daily transactions or treat them as an important warning. Some, including Bullard, warned not to ignore what the markets seemed to say, and he and Kashkari said the Fed should stop raising rates or risk trouble.

When the Fed met in December, policymakers thought that they could fit the circle.

Officials proceeded to a further quarter-point rate increase, as expected at the time, and issued updated projections indicating two further rate increases for 2019 – one less than four months ago. in September, but still progressing.

LOST NUANCE

The Fed, however, hoped that between a slight change in its policy statement and Powell's follow-up press conference, things would remain calm, a strategy that Fed officials later exposed in interviews and in the press. minutes of the December meeting.

Replacing the phrase that the Fed was "waiting" for further rate hikes by another claiming that it was "judged" likely, the central bank tried to show that it was now less committed to a stricter policy.

But that nuance was lost on the markets and Powell's reassurance at the press conference of a new Fed "patient" was also lost when he described the monthly reduction in his holdings until $ 50 billion in assets compared to an "autopilot".

For investors, this has undermined the expected message, as the steady decline in the Fed's holdings has had the effect of tightening financial conditions.

The S & P 500 still lost 7.5% in the days that followed.

Investors said the Fed "was not fully aware" of how the turbulent markets and "softening global data" were putting the US at risk, the Fed's January report said. last in which he analyzed the perception of the December declaration.

"It was a delicate period," New York Fed Chairman John Williams told Reuters on Tuesday. The tweak in the December statement "was a pretty subtle message. This is one of the challenges of trying to communicate in one page a very complicated and complex situation. "

Over the next few weeks, the Fed has avoided all the subtleties in favor of more public recognition that its view of economic reality has changed.

At a Q & A session at the American Economic Association, Mr. Powell came armed with written notes and a key message that the Fed was "always ready to change the money." policy direction and change it significantly "if the situation deteriorated.

After the January meeting, this message became official. References to the new "patient" approach and "moderate inflation", as mentioned in the minutes of the December meeting, have been incorporated into the Fed's policy statement. A longstanding mention of the need for higher rates has been removed.

There has been no opposition to the changes, even those who have been most worried about inflation and financial risks are silent.

It was a moment of significant unanimity for a central bank that spent the last ten years wondering when, rather than whether inflation or financial risks would reappear. Throughout this period, a number of officials – including Powell early in his career in the central bank – have consistently warned that the combination of unemployment, cheap money and billions of dollars injected by the policies Fed in times of crisis would inevitably pose problems.

As the minutes of the Fed's January meeting showed, not all officials announced further rate hikes and some pointed out that a possible turnaround – resolving trade tensions, for example – could cause them to raise their rates.

But for the veterans of the Fed, the bar is now higher. JP Morgan analyst Michael Feroli recently said in a statement released in January that the Fed "was evolving subtly but profoundly" towards a new worldview, in which various forces have changed the way the system works. inflation and rates the bank responds.

GRAPHIC – The new Fed standard: tmsnrt.rs/2VccqWm