The Fed’s actions are undermined by its words
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Cutting interest rates and yet inadvertently tightening monetary policy is a trick few central bankers would be proud of pulling off. This week, the US Federal Reserve managed it. The Federal Open Market Committee delivered a quarter-point cut in rates, its first reduction since 2008. But the remarks from Jay Powell, the Fed chair, in the subsequent press conference seemed to convince investors that the cut was an anomaly.
The financial markets duly undertook a sharp correction, with traders reducing the number of further cuts expected in the medium term, equities falling rapidly and the yield curve inverting further. It seems unlikely that Mr Powell intended this reaction, and his communication skills as Fed chair are still a work in progress. But the Fed’s task at the moment is not easy. It has to contend with a US president perennially injecting uncertainty into the US economy with destructive trade policy and continually sniping at the central bank, and with investors who may have got ahead of themselves in pricing in a series of cuts.
Whether the economy really needed an interest rate cut can be debated. Growth slowed in the second quarter as net trade and business investment — both affected by Donald Trump’s trade war — weakened sharply, while consumption grew rapidly. However, what the economy certainly needs is a central bank that stands ready to react quickly, particularly on the downside, if growth weakens and inflation continues to undershoot. Mr Powell, unfortunately, failed to convey that impression.
The damage was done during the press conference following the decision, in which Mr Powell said that the rate move was a “mid-cycle adjustment to policy” rather than the beginning of a long series of cuts.
Forward guidance on interest rates can play a valuable role, but generally in specific circumstances such as a commitment to hold rates down to prevent deflation. On this occasion, it surprised and disappointed the markets and injected unwelcome volatility.
Of course, it is not the job of the central bank to validate the expectations of financial markets. Mr Powell did not intend for his words to have the effect that they did, given that he also welcomed the looser financial conditions arising from expectations of looser monetary policy that have supported the economy this year. If the Fed thinks investors have it badly wrong and that their misconceptions will make policy-setting harder than normal, the way to correct it is through consistent and broad-based messaging over a period of time, not by springing a surprise in a post-meeting press conference.
The Fed’s job has been made considerably more difficult by the interplay of monetary policy with Mr Trump’s trade war. Mr Powell cited uncertainty over trade as one of the reasons for cutting — a perfectly reasonable analysis but one with the potential to create moral hazard by insulating Mr Trump from the effects of his own actions. The fact that the president continually batters away at the Fed in public also complicates the task. It is all too easy for any monetary easing by the Fed to look like a concession to the White House.
The central bank cannot get into a game of cat-and-mouse with the administration over trade policy or public criticism. It needs to block out the noise and explain how it has formed its view of the economy and monetary policy, and what it will need to see in terms of incoming data to change it. This week’s decision was a reasonable one, but the Fed needs to do better explaining it.
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