The Federal Reserve (Fed) meeting this week marked a significant shift in their policy stance by stressing that they will be "patient". This term was last used by former Chair Yellen in 2016 to reassure markets. Over the course of 2018, Jerome Powell managed to withstand the barrage of criticism from President Trump and the committee seemed unrelenting in their desire to normalise monetary policy to build up some room to respond to the next crisis. As equity markets fell substantially in December, the Fed had remained resolute and hiked rates for a fourth time in the year. What could explain the sharp shift in policy at the meeting this week?
It is important to remind ourselves of three objectives of the Federal Reserve, namely 'maximum sustainable employment, stable prices, and moderate long-term interest rates. These goals are sometimes referred to as the Fed's "mandate." Maximum sustainable employment is the highest level of employment that the economy can sustain while maintaining a stable inflation rate. Prices are considered stable when consumers and businesses don't have to worry about rising or falling prices when making plans, or when borrowing or lending for long periods. When prices are stable, long-term interest rates remain at moderate levels, so the goals of price stability and moderate long-term interest rates go together'. 1
What was notable in December was that, despite the rate rise, bond yields fell. This appeared to be the result of declining inflation expectation. Real yields, the difference between nominal interest rates and inflation expectations, remained broadly unchanged over the course of the month. Inflation expectations had fallen party because of oil prices but it also suggested something more concerning about expectations for the future path of growth. However, after this week's Fed meeting, real yields fell more than nominal yields implying that investors are now expecting less tightening by the Fed and that the economy would continue to grow albeit at a slower pace than last year.
When real yields remained unchanged in December, financial conditions tightened. Credit was especially vulnerable with spreads over government bonds moving sharply higher in December. If this persisted, it would correspond to higher funding costs for business and would ultimately result in eroding business confidence. Following the latest Fed comment, spreads have started to fall again and businesses now have a better idea of potential funding costs.
Overall, the change in Fed policy should be a welcome relief after the fears that excessive rate rises could tip the economy into recession at the end of last year. With price pressures moderating, the need to take immediate action given their objectives, have waned which has been subsequently reflected in their latest stance.
1. Source: www.federalreserve.gov
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