Jay Walking It Back

Fed Chairman Jerome “Jay” Powell will deliver his semiannual monetary policy testimony to Congress on Tuesday and Wednesday. In past decades, this testimony was a huge deal for the financial markets. These days, not so much. The Fed is a lot more forthcoming. Policy meeting minutes are released a lot sooner. Officials are more open in their public comments. The Fed now releases its monetary policy report on the Friday before the scheduled testimony. Still investors will want to pay attention. Meanwhile, delayed government data will arrive this week, providing a clearer picture of the past and, hopefully, pointing ahead.

In its Monetary Policy Report to Congress, the Fed noted that economic activity appeared to have increased at a “solid” pace in the second half of 2018 and “the FOMC judged that, on balance, current and prospective economic conditions called for a further gradual removal of policy accommodation.” However, “in light of softer global economic and financial conditions late in the year and muted inflation pressures, the FOMC indicated at its January meeting that it will be patient as it determines what future adjustments to the federal funds rate may be appropriate to support the Committee’s congressionally mandated objectives of maximum employment and price stability.” The financial press described this a flip-flop, a major U-turn. Bloomberg News said it was “the biggest policy about-face in years.” As if. The Fed went from a mild tightening bias to a seemingly neutral stance (though most officials still anticipate that higher rates may be needed). In his January 30 press conference, Chairman Powell said that “common sense risk management suggests patiently awaiting greater clarity – an approach that has served policymakers well in the past.” The Fed merely responded to increased downside risks – risks that had intensified in late December and early January.

The minutes of the January 29-30 FOMC meeting showed that “several meeting participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook.” However, “several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year.” So, if we get a reduction in the near-term risks, then we may see the Fed edge short-term interest rates higher. The partial government shutdown is behind us and we may reach a trade agreement with China. However, uncertainty about Brexit remains.

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No surprise, the balance sheet was a key item for discussion in January. While many financial market participants felt that the unwinding of the balance sheet was a key factor in the stock market’s decline (from October), the Fed begs to differ. Officials thought that the unwinding “would put some modest upward pressure on Treasury yields and agency mortgage-backed securities (MBS) yields over time,” but “they generally placed little weight on balance sheet reduction as a prime factor spurring the deterioration in risk sentiment.” Still, “some other investors reportedly held firmly to the belief that the runoff of the Federal Reserve's securities holdings was a factor putting significant downward pressure on risky asset prices, and the investment decisions of these investors, particularly in thin market conditions around the year-end, might have had an outsized effect on market prices for a time.” Policymakers hypothesized that investors may have misread the Fed’s intentions, that it would be inflexible (on rates and the balance sheet) to changing economic conditions. In early January, officials began to emphasize that the Fed would be “patient” in considering adjustments to short-term interest rates and “flexible” in managing reductions to its balance sheet. That seemed to do the trick – “on balance, stock prices finished the period up almost 5 percent while corporate risk spreads narrowed, reversing a portion of the changes in these variables since the September FOMC meeting.”