How Durable Is the Fed’s Dovish Turn?

The Federal Reserve’s recently communicated change in its outlook for monetary policy has led to concerns that the Fed is overreacting to market volatility, or worse, succumbing to political pressures. However, we believe there is a more compelling reason for the dovish shift.

Policymakers are now faced with the possibility that the current level of the federal funds rate (2.25%–2.5%) is the terminal level of this cycle. This is important because it implies that, in the event of an economic downturn, the Fed has less room to stimulate the economy by cutting interest rates before hitting the effective lower bound.

A more limited capacity of conventional monetary policy tools to offset an economic downturn strengthens arguments that the Fed should take additional steps to combat the limitations of the effective lower bound when times are good. One possible way to do this is by not only tolerating an inflation overshoot, but targeting it.

At or near neutral

After laying the groundwork in early January, Federal Reserve officials used the January FOMC (Federal Open Market Committee) statement to more forcefully communicate two points: 1) they no longer see a need for restrictive monetary policy and 2) they view monetary policy as more or less neutral.

This is an abrupt change from communications last summer, when virtually all Fed officials were forecasting that the terminal level of the current hiking cycle would be above their estimate for the longer-run neutral interest rate. It was also a notable difference from mid-December, when the forward guidance of the FOMC statement still contained the hiking bias featured in every statement since December 2015.

The apparent change in monetary policy strategy led some observers to ask whether the Fed is overreacting to recent market volatility. While this is possible, we think there is a more compelling explanation. Namely, we think many Fed officials now see a good chance that the current range of the fed funds rate (2.25%–2.5%) is the terminal level of this cycle – a level notably lower than most of them had previously expected (in December, the median FOMC participant projected a terminal level of 3.1%).

After all, this year’s equity market rally has likely been driven more by lower real interest rates and the Fed’s pivot than by lower equity risk premiums or higher earnings expectations. Furthermore, recent indicators of moderating real growth in interest-rate-sensitive sectors (e.g., housing, autos, commercial and industrial loans) could have surprised some who thought that the post-crisis U.S. economy is less interest-rate-sensitive.

Conventional policy tools may not be enough

This is important because if monetary policy is already at or near neutral when the fed funds rate is 2.25%–2.5%, then the FOMC should reduce its estimate of how much future reductions in interest rates could stimulate the economy. Adding to these concerns, various cross-currents – including slower global growth and general government policy uncertainty – are likely to weigh on growth in 2019.

Taken together, these trends could paint a darker picture of U.S. economic prospects, and argue for the Fed to expand its tools to counter the constraints of the effective lower bound. In the wake of the 2008 financial crisis, when the lower bound was binding, the Fed deployed a wider range of tools to stimulate the economy (asset purchases, forward rate guidance, etc.). Since that time, the Fed has taken steps, including allowing the balance sheet to shrink, to ensure that it remains a policy tool in the future.

However, policymakers could also look to create more “room” to hike interest rates when times are good. By raising inflation expectations, or at least working to ensure expectations remain anchored at the Fed’s longer-term target of 2% PCE (personal consumption expenditures), the Fed could potentially further raise nominal interest rates over time.

Will the Fed consider average inflation targeting?

Exacerbating concerns around monetary policy capacity, various survey- and market-based measures suggest that inflation expectations have drifted lower over the last few years. This has occurred as, until recently, realized inflation has remained below the Fed’s longer-term target.

One potential way to re-anchor them is to adopt an average inflation targeting framework like the one proposed by New York Fed President John Williams in his recent speech and paper. Importantly, the framework, if implemented now, would not just tolerate some above-target inflation – it would make it an explicit policy goal.

In this context, perhaps the Fed’s recent pivot isn’t an overreaction to data. Rather, it may suggest a more ingrained bias to accommodate continued growth, anchor inflation expectations and ease the monetary policy constraints.

To be sure, we don’t believe the Fed is on the cusp of announcing a formal change to its longer-term framework (at least not at its next meeting). However, we do think some shift in strategy is possible and perhaps contributing to the Fed’s recent policy pivot.



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