Reviewing the Fed’s sharp Policy U-turn in 2019


After 4 rate hikes in Y 2018, the Fed cut interest rates 3X in Y 2019, making a remarkable and sharp U-turn in its monetary policy.

The big shift reflected that Fed officials’ assessment of potential risks to the US economy has dramatically changed over the course of the year, due to slowing global growth, rising trade tensions and muted inflation pressures.

Fed officials seemed confident that the three insurance rate cuts in Y 2019 have helped engineer a soft landing of the economy. Barring a “material change” in the economic outlook, they plan to hold rates steady through Y 2020.

A year ago, the Fed raised the target range for the federal funds rate to 2.25 to 2.5%, the 4th rate hike in Y 2018 and the 9th such move since late Y 2015, when the central bank started the process of monetary policy normalization.

Meanwhile, Fed officials anticipated that they need to raise interest rates at least 2X in Y 2019 to slow the economy and keep inflation from spiking.

Toward the end of 2018, there was still a sense the economy was growing at around 3%,” Fed Chairman Powell recalled at a press conference earlier this month. “We took steps to make it (rates) less accommodative, and that seemed to be the right thing.”

However, prompted by rising risks to US growth in the months ahead, the Fed shifted its stance at the beginning of Y 2019, pledging to be “patient” about future rate hikes.

In March, the Fed signaled no rate hikes in Y 2019 and announced plans to conclude shrinking the balance sheet in September, taking another step to avoid over tightening monetary policy.

In July, the Fed lowered interest rates for the first time in more than a decade, amid rising concerns over trade tensions, a slowing global economy and muted inflation pressures.

After the US bond market in August sent warning signs of a possible economic recession, the Fed cut rates again in September and October. These policy adjustments put the current federal funds rate target range at 1.5 to 1.75%.

“I don’t think anybody saw it coming. The challenges that we faced this year, I think they were a surprise,” Mr. Powell said, adding that weaker global growth and persistent trade tensions weighed on the US economy.

As the year progressed, we adjusted the stance of monetary policy to cushion the economy from these developments and to provide some insurance against the associated risks,” he said.

The US economy expanded at an annual rate of 2.1% in Q-3 of Y 2019, up from the 2% growth rate in Q-2 but a deceleration from 3.1% in Q-1, according to the Commerce Department.

In mid-October, the Fed also announced that it would begin expanding its balance sheet by buying about $60-Ba month in Treasury bills, in an attempt to provide more accommodation to the economy.

The new QE partly reversed the process of shrinking the Fed’s balance sheet, which started since October 2017.

But Mr. Powell emphasized that the action differed from the bond-buying program, or QE, that the central bank deployed during the financial crisis, because it was intended to facilitate short-term lending to help control its benchmark interest rate.

He has publicly characterized the recent rate cuts as a “mid-cycle adjustment,” similar to the adjustments the Fed had made in Ys 1995 and 1998, as opposed to the beginning of a prolonged easing cycle.

During both frames in Ys 1995 and 1998, the Fed also cut rates 3x, a total of 75 bpts, to prevent an economic downturn and sustain the expansion before raising rates again.

But there are still Key differences, particularly around inflation, between now and those 2 frames in the 1990’s, according to Chairman Powell.

“Inflation is barely moving up, notwithstanding that unemployment is at 50-year lows and expected to remain there. So the need for rate increases is less,” Chairman Powell told reporters at his press conference in December.

I think we’ve learned that unemployment can remain at quite low levels for an extended period of time without unwanted upward pressure on inflation.” he said.

The price index for personal consumption expenditures (PCE), the Fed’s favorite inflation indicator, increased 1.5% over the 12 months through November, still below its target of 2%.

“The threshold to raise rates is still much higher than the threshold to cut rates going forward. Powell made it clear that he would need to see a sustained period of inflation before he raises rates,” said the chief economist at Grant Thornton, a major accounting firm.

The median estimate for the federal funds rate is at 1.6% at the end of Y 2020, suggesting no rate cuts or hikes in Y 2020, according to Fed officials’ interest rate forecasts released in December.

“This reinforces our view that with the 2020 elections approaching, the Fed will keep interest rates on hold,” said Bruce WD Barren, Chairman of the EMCO/Hanover Group, an international capital and tax consulting firm.

“In short, the Fed thinks it can err on the side of caution and has room to maneuver should the trade war intensify or if there is an exogenous shock to the economy,” Mr. Barren added.

An economist at PIMCO, a global investment management firm, believed that positive signs in the US economy since the rate cut in October seem to have increased the Fed’s confidence that its “mid-cycle adjustment” has helped engineer a soft landing, and that further cuts are unnecessary.

Eric Rosengren, President of the Federal Reserve Bank of Boston said last week that he did not see a reason for the central bank to change interest rate policy, that the US economy is currently well positioned for the coming year.

Given that monetary policy works with lags, and Federal Reserve policymakers have already eased monetary policy 3 times in 2019, my view is that it is appropriate to take a patient approach to considering any policy changes, unless there is a material change to the outlook,” he said.

Shayne and I believe that persistently low inflation could force the Fed to cut rates at least once again in Y 2020.

Meanwhile, President Trump has, and continues to pressure the Fed to lower interest rates to boost economic growth.

Would be sooo great if the Fed would further lower interest rates and quantitative ease. The Dollar is very strong against other currencies and there is almost no inflation. This is the time to do it,” President Trump Tweeted recently.

Have a Happy New Year Week!