What Is The Real Reason For The Fed's Sudden Decision To Stop Raising Interest Rates?

The Fed has put the brakes on. At its latest monetary policy meeting, the FOMC left interest rates unchanged and said it would be “patient” about further interest rate rises. Furthermore, the FOMC’s  forward guidance about the pace of balance sheet reduction says that it is “prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments,” including reversing course and doing more QE if necessary. Yet only a month ago, the Fed was signaling two interest rate rises in 2019 and no change in the pace of balance sheet reduction. What has caused this sudden change of heart?

It doesn’t seem to have anything to do with domestic economic conditions. The economic report is distinctly upbeat: job gains are strong, unemployment is low, and inflation is near the Fed’s target of 2%. In fact, it all looks much the same as it did in December. Nevertheless, the FOMC is clearly seeing some change in the economic outlook that justifies a considerable softening of its stance.

At the press conference, the Fed’s chair, Jay Powell, identified several concerns that influenced the FOMC’s decision. Slowing global growth, especially in China and the Eurozone; tightening market financial conditions, which tends to amplify the Fed’s own monetary tightening; and the U.S. government shutdown, were all factors. They all create headwinds for the U.S. economy that could in due course mean slower growth, lower inflation and rising unemployment.

Thus, on the face of it, pausing interest rate rises appears a prudent move until more is known about the persistence of these headwinds and their effect on the U.S. economy. So too is forward guidance that if economic conditions were to deteriorate considerably, the Fed would abandon normalization and revert to ZIRP and QE. People need to know that hawks can become doves.

However, Greg Ip of the Wall Street Journal thinks the Fed is signaling not a pause, but a complete halt in interest rate rises. And he has a theory about why the Fed has suddenly decided to end monetary tightening:

In the last six weeks Mr. Powell does seem to have shifted his views on inflation risk. He seems to have concluded that the lowest unemployment in 50 years isn’t going to push inflation back above 2% anytime soon, and that would be a prerequisite to tightening again.

If real rates above 0.5% are a threat to both economic growth and 2% inflation, then that suggests the economy is fundamentally more fragile than in the past.

And he goes on to argue that the economic fragility that renders higher interest rates unsustainable is not confined to the U.S., but is a global phenomenon. Something has fundamentally changed since the 2008 financial crisis.

It is evident that the relationship between unemployment and inflation has broken down. unemployment is now at historic lows, yet there is no sign of any resurgence in inflation. But as I have noted before, in today’s world of low barriers to trade and extended supply chains, competition for lower-skilled jobs is often global, rather than domestic. As long as there is cheaper labor somewhere in the world, companies have no incentive to raise wages in response to tighter domestic labor markets. Anyway, it is questionable how tight the U.S. labor market really is. Underemployment, in the form of short hours and unstable work, is still prevalent, which suggests that there is still considerable slack in the labor market. And the prime age participation rate is still well below historical norms. So, it may be that inflation remains low because there simply isn’t much upwards pressure on wages.

The right question to ask, therefore, is not why inflation is low, but why the U.S. economy – and indeed most other developed economies – appears to be incapable of generating sufficient good quality jobs to occupy its prime working-age population productively. In my view, this is a function of labor market changes going back decades, such as offshoring of manufacturing jobs and the rise of service jobs, systematic dismantling of unions and weakening of labor bargaining power, and the mass entry of women to the workforce in a culture which – even now – tends to value the work of women less than that of men.

A less than entirely productive working-age population might depress growth, and hence real interest rates. This might indeed justify a halt to interest rate rises. Indeed, the Fed probably should not have been raising rates at that pace at all. The strong growth induced by the Trump administration’s tax cuts was merely a “sugar high” and bound to fizzle out. It did not justify monetary tightening. And the administration has done little to increase productive employment and generate strong sustainable growth. It has instead wasted a great deal of time on fruitless and damaging trade wars, not to mention an economically lunatic government shutdown.

For some time now, there have been clear indications that the Fed was raising rates too far and too fast. For example, the yield curve came dangerously close to inverting in December, which is a sign that monetary conditions are too tight for the economy. So the halt to rate rises is welcome. However, I don’t think the Fed’s decision has anything to do with the labor market. I think it is about the stock market.

Since 2016, there has been a considerable stock market boom. But in the last few months, as the Fed’s balance sheet reduction has accelerated, this has somewhat chaotically reversed. The S&P 500 took a nosedive:

Although it recovered somewhat in January, there are nonetheless dire warnings that this could be the start of a bear market.

Because the American economy is intimately linked with the stock market, a downwards trend for stock prices can mean a poorer economic outlook. So, even before the FOMC’s announcement, markets had already concluded that the Fed would probably stop raising rates. Although stocks rose and the dollar fell, the announcement elicited less response from markets than might have been expected, given the suddenness of the policy reversal.

But the Fed’s mandate is to target unemployment and inflation, not stock market performance. Why would the FOMC take a stock market reversal as a signal to stop rate rises?

Joe Wiesenthal at Bloomberg has an explanation. “The more dovish stance that the Fed took yesterday has renewed claims that there is a ‘Fed put’ or a ‘Powell put’ out there in the market,” he writes in today’s Markets newsletter. “In other words, for as much as they talk about focusing on the real economy, there’s a deep-seated suspicion that they want to avoid a sustained drop in the stock market, thus subsidizing risk-taking investors.”

So the FOMC’s decision, and its forward guidance, could simply be intended to prop up the stock market. Wiesenthal thinks that Powell admitted as much at the press conference:

Powell said a sustained tightening of financial conditions (as seen through stocks, currency, interest rates and credit spreads) had to be watched because it could have important macroeconomic implications. And then he said: “In fact our policy works through changing financial conditions, so it’s sort of the essence of what we do.”

If the FOMC’s decision was indeed driven by the stock market’s recent tantrum, then the future path of interest rates  will depend on whether bulls or bears are dominant. I suppose this could be reasonable, if you believe that propping up Wall Street generates productive jobs and economic growth. But it seems a long way removed from what we usually think of as the purpose of interest rate policy, which is to influence business investment and household spending. Has the dominance of Wall Street in Fed policy gone too far?

The Fed has not given an adequate explanation for the pace of interest rate rises last year, which appeared unjustified in terms either of the Fed’s mandate or key economic indicators. And now it hasn’t given an adequate explanation of this sudden softening, either. Are the FOMC’s decisions really driven by unemployment and inflation – or are they more influenced by the stock market? I think we should be told.