Adrift: Has Monetary Policy Become Unanchored?

In light of the Federal Reserve’s recent interest-rate cut, our Fixed Income CIO Sonal Desai takes a look at how US central bank thinking seems to have changed, and whether there’s a risk of having interest rates too close to zero. She argues deflation risks are overblown and looser monetary policy will lead to increased financial market distortions.

The Federal Reserve’s (Fed’s) interest rate cut last month was unnecessary, in my view. I think the US economy is doing okay, deflation risks are overblown and looser monetary policy will increase financial market distortions. Here, however, I want to flag a deeper concern: I fear that monetary policy has lost its anchor, and the Fed lacks conviction and direction. In this piece, I discuss the reasons and the implications for investors.

Conviction on the Fed’s monetary policy framework has evaporated.

Central bankers often fear that inflation expectations might become unanchored.

I fear that monetary policy itself has become unanchored.

The US Federal Reserve (Fed) has offered a mishmash of justifications for its decision to cut rates at its July meeting: (1) as insurance against global trade uncertainty; (2) to boost inflation; and (3) to make the job market even hotter. With so many different reasons, the Fed can pick and choose—and ignore the hard data showing a robust economy led by strong employment and consumption.

On Target

I have argued that the Fed simply caved to market pressure. Harvard’s Robert Barro suggested it might have succumbed to political pressure.1 The two are observationally equivalent, since markets and politicians are both clamoring for lower interest rates.

You are more likely to cave in to pressure when you lack conviction in your own ideas. And, conviction on what monetary policy should try to achieve—and how—appears to have evaporated.