Central bank watchers will readily agree that the policy meeting this week marked the formal end of the first attempt by Chair Jerome Powell’s Federal Reserve to lead markets rather than succumb to their will. What they are less likely to agree on are the major reasons for the shift, and it is the answer to this latter question that will determine whether the Fed is likely to make another effort toward greater separation and policy independence from markets.
Early in its tenure, the Powell-led Fed sought to convey to markets a heightened focus on the further normalization of monetary policy, as it sought to build policy flexibility in the event of a future downturn and to lower the risk of future market instability. This approach was codified in three key ways: gradual and consistent hikes in interest rates, signaling of further meaningful increases, and a predictable and clearly telegraphed reduction in the balance sheet, which had grown to an unprecedented size due to the program of large-scale asset purchases, known as quantitative easing.
Markets started to become increasingly uncomfortable with this approach amid concerns about slower growth internationally, increasing U.S.-China trade tensions, and stretched market valuations. Even though the economy’s performance remained solid, these worries resulted in a major market sell-off when, rather than show greater sensitivity to the more uncertain context, Fed officials raised their forecasts for rate hikes and reiterated that balance-sheet normalization was on “autopilot.”
As the sell-off intensified, it also risked getting disorderly, forcing the Fed to begin changing its narrative. A series of central bank officials came out in favor of a less aggressive pace of future rate hikes than was formally signaled by their blue dots. Officials also hinted at the possibility of a less rigid approach to the balance sheet. And all this happened even though U.S. labor market indicators have continued to go from strength to strength.
The Fed’s statement on Wednesday contained the two things investors most wanted to hear: that the central bank would be “patient” on future rate hikes, and that it would be flexible when it came to its balance sheet. In the process, the Fed’s announcement ticked off every one of the issues I suggested in this article earlier this week. The markets had a textbook reaction to the Fed statement: stocks soared, the dollar weakened and interest rates moved down.
Analysts will offer many explanations for the striking 180-degree shift.
Some commentators will argue that the Powell-led Fed has now learned what its two predecessors did: that a highly levered economy means that, when push comes to shove, markets end up leading central banks rather than the other way around. Others will see the change of course as evidence of the Fed succumbing to political pressure. Some will see it as an acknowledgment of the sensitivity of the U.S. economy to spillbacks from declining economic momentum in Europe and China. And yet others may even see it as a signal that the Fed feels that the weaker gross domestic product growth that is likely to materialize this quarter is due to more than the partial government shutdown.
The first two reasons suggest that central bankers will not be overly eager to try to break their dependency on markets, at least any time soon. In other words, the “Fed put” is back in the money, and will remain so. The other two reasons suggest a higher possibility of a Fed policy reversal down the road.
To me, the most salient takeaway is that the calibrated removal of unconventional measures is proving a lot trickier than many expected. There is no reason to think that this will change anytime soon absent a marked improvement in the global economy. With that, central banks will inadvertently continue to be occasional amplifiers of market volatility, up and down — a far cry from their previous role as effective volatility repressors.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”
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