When Federal Reserve officials started a rate-hiking cycle last month, they hoped their widely telegraphed policy action would neither derail the recovery nor overly destabilize financial markets.
As hard as it was for the officials to gauge exactly the extent of the financial markets' dependence on Fed support, they couldn’t have also anticipated that a series of uncharacteristic policy mistakes by China, along with another steep drop in oil prices, would throw off market sentiment.
This week, the Federal Open Market Committee, the Fed's top policy-making venue, will meet as markets are undergoing a transition in both volatility and liquidity, which has accentuated the “unusual uncertainty” besetting the global economy.
Here are four indications of what Fed officials are likely to do and not do:
- The Fed will not repeat its 25 basis-point interest rate hike of December. Further tightening would risk fueling the volatility in markets. Moreover, liquidity conditions already have tightened as a result of recent market developments. As a result, the Fed will wish to avoid aggravating the risk of market instability contaminating economic fundamentals.
- The Fed will not reverse course and cut interest rates. There is no compelling evidence of a material weakening in the U.S. economic outlook, at least for now. Fed officials would worry, correctly, that such a move could be interpreted as an act of policy panic, which would further spook companies that already are hesitant to deploy their large cash balances into higher capital spending,
- The Fed’s narrative will acknowledge the recent market volatility, coupled with the risk of further economic weakening abroad. But the central bank's communication will not dwell on this. Also, unlike European Central Bank President Mario Draghi did last week, Fed officials will not meaningfully raise market expectations of policy accommodation in future. Instead, they will reiterate that they remain watchful and data dependent. In doing so, they will try to strike a tricky balance between reassuring markets and avoiding giving the appearance that markets dictate policy reactions.
- Although this will be more clearly reflected in the meeting’s minutes that will be released in a few weeks than in the immediate statement, Fed officials will acknowledge implicitly that their policy confidence is not as high as they would like it be; and understandably so. In addition to the uncertain global economic and market outlook, there are questions about the exact impact of policy measures, including the manner monetary policy changes economic behaviors. There will be indications that the views of individual Fed officials are starting to diverge once again, after a period of relative unity. Such lack of consensus would be understandable given the stronger component of judgement that is now required.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the author of this story: Mohamed A. El-Erian at firstname.lastname@example.org
Mohamed El-Erian is the chief economic adviser at Allianz SE. To read more of his blogs, CLICK HERE NOW.
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