The change of the US monetary policy trend has been radical since the end of January. At its January 29/30 meeting, the Fed said it was no longer committing to one or more rate hikes, which was confirmed in March when the “dots” chart was published, and it was going to stop the downsizing of its balance sheet, which it confirmed at its March meeting, indicating a balance sheet target of 17% of GDP in the autumn. The key elements explaining this radical change lie in the international environment. The Fed sends the signal that because of the uncertain global environment, it wants to remain agile by no longer committing on future movements.It even gives the feeling of wanting to limit its “forward guidance” in order to have more leeway in its monetary policy management.
This role of the international environment may be a source of surprise as the economy is self-centered. Its opening rate is 14% in 2018 against 19% in the Euro zone. A research by Laurent Ferrara and Charles-Emmanuel Teuf at the Banque de France, quoted by Fed’s Richard Clarida in a recent BdF colloquium, suggests that the international environment is a key factor in the reasoning behind FOMC’s decisions . The authors create an index containing terms related to the global economy, and integrate it into a Taylor formula. The addition of this indicator in the Taylor Formula , that links interest rate to economic activity and inflation, is significant. Greater attention to these external factors is driving the Fed to more accommodating behavior. We can therefore better understand the change in tone of the US central bank since the beginning of the year. The international environment has deteriorated rapidly (see graph below) and the Fed is taking into account even if its economy remains robust. See the initial post of Laurent Ferrara and Charles-Emmanuel Teuf on the Banque de France blog The graph below traces the pace of their index from 1993 to 2017
The following graph shows a Global Economic Policy Uncertainty Index. It suggests and validates the wait-and-see attitude of the Fed in 2016, but emphasizes the opportunity given to it in 2018 to tighten the tone with lower tensions as measured by the index. The year 2019 actually suggests more wait-and-see.
The end of the reduction of the Fed’s balance sheet is what we have to keep in mind after the publication of the minutes of the last FOMC meeting. It will take place during the second half of this year.
The US Central Bank does not want to be too constrained in the management of its monetary policy. The pace that was taken and the level targeted until then could add to the difficulty of the good calibrage of the monetary policy.
The Fed clearly does not want to be constrained in its choices because the global environment which is now more uncertain.
The way Yellen initiated the downsizing movement of the balance sheet was possibly compatible with a stable and predictable international environment. The arrival of Trump has created noise and spillover effects because of its policies. Now the Fed must take into account these noises and the risk of contagion which are attached to them.
The Fed does not yield to Trump by not raising rates, but it does not raise them in order to be able to intervene quickly to contain the negative effects of the policy pursued at the White House. She wants to be agile to limit risks. It’s well thought out.
The latest FOMC meeting on
January 29 and 30 saw confirmation of the halt to monetary normalization, with
the end to the Fed funds hike cycle and an easing in the Fed’s balance sheet
management (reduction) policy, although the exact terms of this remain to be seen.
The most surprising part about this decision is that it was dictated by the
threat of shocks from external factors (Brexit, China, etc.) rather than the
desire to tackle any domestic problem, marking the first time that the Fed has
taken this kind of decision to normalize monetary policy without making a
direct reference to its domestic economic situation.
Yet the shift in monetary policy direction could have been based on purely
internal considerations rather than referring to potential external shocks, so
this move raises a number of questions.
The US Federal Reserve decided to bring its monetary policy normalization to an end during its meetings on January 29 and 30, 2019. The interest rate hike cycle had kicked off slowly in December 2015 and stepped up a pace a year later, as nine interest rate hikes pushed the Fed Funds rate up from 0.25% (upper end of range) to 2.5% in December 2018. During last week’s press conference, the Fed Chair indicated that Fed Funds are now in the range of neutral, in response to the first question from journalists: there is no longer an accommodative or a tightening slant. Powell’s confidence in the strength of the US economy suggests that the end to normalization should not just be seen as hitting the pause button for a while.
The rate hike cycle has been long and slow-moving if we compare to the Fed’s previous series of tightening moves from 2004 for example. A comparison with this period also reveals that real interest rates on Fed funds were much higher then than they are now. The figure is currently marginally above the level witnessed at the start of the normalization process in December 2015, unlike the situation after 2004, when the economy was much more restricted, while this is not the case in the current economic situation.
A comparison of current real interest rates with previous phases of monetary tightening shows that today’s situation is completely different to these episodes. Real interest rates in November 2018 stood at around 0.4% (inflation figures for December are not yet available on the PCE index), which is much lower than figures in 2006, 1999 or 1990. Does this mean that the US economy is too weak to be able to deal with a real rate above 1%? This would be extremely worrying and would undermine Jerome Powell’s comments that the US economy is in a good place.
It is difficult to understand why
US normalization is coming to an end when we look at the economy, as unemployment
is near its low, so the central bank should be tightening the reins. The Fed’s
projections for 2019 and 2020 are for figures above the country’s potential
growth rate and this also fits with the economists’ consensus, at least for 2019.
Against this backdrop, monetary policy needs to be tighter to ensure that
growth does not create imbalances that then have to be addressed, and this was the
message from Powell in 2018, when he suggested that fiscal policy (too
aggressive for an economy running on full employment) would need to be offset
by tighter monetary policy to rebalance the policy mix. During the press conference
on Wednesday January 30, he did not raise this question: the issue was side-stepped,
but yet the analysis still remains the same. There are only two possible
economic explanations for the halt to normalization: either there are
expectations of a severe downgrade to projections when they are updated in
March, but this would not be consistent with Powell’s comments; or the Fed is
doing whatever it takes to extend the economic cycle at any cost, with the end
to the rate hike cycle aimed at cutting back mortgage rates and taking the
pressure off the real estate market. However, with the overall economy
remaining robust, the risk of this type of move is that it could lead to imbalances
that would be difficult to eliminate. This is the opposite approach to the Fed’s
strategy right throughout 2018, so it would be a strange tactic.
The Fed raised its benchmark rate by 25 basis points. The fed funds rate will thus evolve in the 2.25 – 2.5% corridor. This rate level is close to the corridor, 2.5-3.0%, considered by the Fed as a long-term target. This is the 4th rise this year.
The central bank does not appear worried about the pace of the economy in the coming months. Growth will slow down somewhat in 2019, but the unemployment rate will remain close to its current level, beyond full employment. Inflation will be close to 2%. It is a little weaker than at the September meeting because of the drop in the price of oil.
The Fed said it could raise its benchmark rate twice in 2019. In September, at the previous meeting, it was considering 3 rises. The pace of oil prices and its effect on the inflation rate probably explain this lessening.
Why two further hikes: the economy still operates on a trend beyond full employment. This imbalance must be offset by a monetary policy that must become a little restrictive to avoid possible imbalances, currently not very visible but that could develop in the not too distant future. The economy has changed, but not so much that it can function too long beyond full employment without having consequences that are difficult to manage in the long run. In addition, the White House policy that fuels domestic demand is resulting in a rapid rise in imports (see here). Through a somewhat restrictive monetary policy the Fed must weigh on the demand and limit the external imbalance.
The ECB puts all its energy on it but inflation does not converge frankly towards the objective (2%) it has defined. Can we say, like Mario Draghi, that the Quantitative Easing has worked properly? Yes probably on the activity. The fall of all the interest rates has modified the inter-temporal trade-off on consumers’ side favoring the immediate expenses to the detriment of the future expenses. On inflation? Yes, if the recovery helped to avoid deflation but beyond? We can wonder. Convergence towards the ECB’s target is postponed year after year. Forecasts on growth (convergence towards potential in 2021 estimated at 1.5% by the ECB) and on inflation, suggest, except to change the reaction function, that the ECB will remain accommodative for a extended time.
The ECB will not start the normalization of its monetary policy in 2019. The interest rate level will remain stable, my bet is that the refi rate and the deposit rate will remain at the current level in 2019.
The lack of external impulse, the slower momentum in the manufacturing sector and the convergence of the headline inflation rate to the core inflation rate are three reasons that suggest that the ECB will not take risks in the management of its monetary policy. The monetary policy normalization, even the expectation of it, may weaken economic activity. Therefore it’s not the good policy when the inflation rate is way below the ECB target with no convergence to the target in a foreseeable future.
The framework I have in mind is the following: Due to more heterogeneous behaviors and uncertainty at the political level, global growth will become, in 2019, weaker than in 2017 and in 2018. Inside the Euro Area, there are no coordinated policies that may boost growth, therefore growth trajectories will converge to potential growth. This framework is not a source of monetary policy normalization. But we can add that the dramatic oil price drop in recent weeks (due to excess supply in the US and in Arabia) will push the headline inflation rate to the core inflation rate which has been close to 1% for months. It’s still way below the ECB target and therefore not a source of monetary policy normalization. Continue reading →