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Fed Starts Getting Pulled in Different Directions

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By Monday, 10 December 2018 10:05 AM Current | Bio | Archive

The run-up to the Federal Reserve’s rate-setting meeting on Dec. 18-19 is sure to intensify a debate on the central bank’s policy stance. It is a difference of views that, although unlikely to be resolved any time soon, shed important insights on a likely contributor to higher and, at times, unsettling market volatility. 

Some point to the recent turmoil in financial markets and the slowing global economy as signs that the Fed has already gone too far in normalizing monetary policy through realized and intended measures. They point to the recent sharp selloff in stocks and the repeated cuts in global growth projections. They welcome what they regard as an overdue walk back by Fed Chairman Jerome Powell; and they anticipate a downward revision of the central bank’s economic projections and its blue dots (that is, guidance on the path of future rate hikes) when he and his Federal Open Market Committee colleagues meet next week.

Others feel that the Fed has, once again, blinked too early. Having turbocharged asset prices and decoupled them from fundamentals through many years of unconventional measures to boost the economy, they argue that a market pullback was not only unavoidable but overdue and desirable. To support their position they point to continued indicators of the U.S.’s economic strength (including Friday’s employment report showing job creation well above what’s need to absorb new entrants, wage growth of more than 3 percent, and unemployment of just 3.7 percent) and the need to reduce the risk of future financial instability. They further complain that the Fed’s haste in returning to the old “data-dependent” stance renders the central bank hostage to markets, as well as undermining its longer-term policy credibility -- what some complain is “flip-flopping.”

This difference is an important one.

Under the first viewpoint, a softening of the Fed’s monetary stance reduces the possibility of a policy mistake that could have caused destabilizing financial-market turmoil, risked an unnecessary economic slowdown in the U.S. and pulled the rug out from a weakening global economy. As such, the Fed isn't just keeping its options open, but also providing important economic and financial insurance.

But if the second viewpoint is correct, the policy mistake is a very different one. It is the postponement of inevitable financial readjustments that would hit the U.S. during a future period of greater vulnerability, rather than when the domestic economy is strong and resilient.

There are at least three reasons why we shouldn't expect a clear resolution of these two competing views any time soon. They are related to technical considerations, economic shortfalls elsewhere and key policy designs that the Powell Fed has inherited.

Part of the recent market selloff reflects the repositioning of the trading and investment portfolios of shorter-term and more agile market participants who had profitably ridden the big wave of ample and predictable liquidity and are now returning to less-extreme-risk portfolio positions. The weak signals about what this means for the economy’s well-being is further confused by distortions in other traditional indicators for financial markets and the real economy, such as the flattening and partially inverted yield curve for U.S. government bonds.

Another part reflects developments abroad that are not related to the Fed. This includes political conditions in Europe’s five-largest economies -- France, Germany, Italy, Spain and the U.K. -- that undermine the much-needed policy transition from a cyclical bounce back to durable and robust long-term growth. The same can be said of China’s economic outlook, which reflects the combined impact of trade tensions and the inherent complications of this stage of the country’s middle-income development. 

Then there is the policy design that the current team of central bankers inherited -- one that puts balance-sheet reduction on automatic pilot. While understandable in terms of seeking to partially anchor market expectations, it’s a policy normalization mix that imposes a heavier burden on the interest-rate tool in an environment of considerable uncertainty.

Rather than try to rely on one viewpoint or the other, market participants would be well advised to think of the Fed’s current predicament as an illustration of two realities that will be with them for a while: First, the Fed confronts a serious challenge in threading the policy needle, in large part for reasons that are well beyond its control. Second, market participants should view today's policy uncertainty as not just inevitable but also as a continuing contributor to higher and, at times, unsettling volatility.

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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The rationale for raising rates amid increasing market turmoil seems a bit murkier.
fed, pulled, different, directions
Monday, 10 December 2018 10:05 AM
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