The Fed muddies the waters

The latest FOMC meeting on January 29 and 30 saw confirmation of the halt to monetary normalization, with the end to the Fed funds hike cycle and an easing in the Fed’s balance sheet management (reduction) policy, although the exact terms of this remain to be seen. 

The most surprising part about this decision is that it was dictated by the threat of shocks from external factors (Brexit, China, etc.) rather than the desire to tackle any domestic problem, marking the first time that the Fed has taken this kind of decision to normalize monetary policy without making a direct reference to its domestic economic situation. 

Yet the shift in monetary policy direction could have been based on purely internal considerations rather than referring to potential external shocks, so this move raises a number of questions.

The situation cannot be compared with the past 

Statements pointing to the end of monetary tightening after past FOMC meetings outlined risks on economic growth as the major factor in the shift, along with the possibility of continued high inflation, and these are the two usual reasons that the Fed gives when it makes moves to halt normalization. The process is very straightforward: the economic cycle creates tension that leads to nominal pressure (inflation), so higher interest rates would dent economic activity, and it is therefore important in this situation to put a stop to normalization to avoid hampering the economy.

The Fed’s reaction function has changed 

In our current example, the Fed stated that the economy is in a good place and that inflationary risk is limited. Falling oil prices since the Fall have changed the profile of future inflation and that could be enough to change tack on monetary policy. So it is worth wondering why the Fed used external factors as its explanation when the US economy is not very open to external influences and has been that way for many years: the impact of an outside shock would not be that huge. 

Does it want to muddy the waters so that its strategy is not so easy to interpret?

Bernanke and Yellen took all the necessary steps to ensure that investors could easily take on board the Fed’s policy responses in their projections with the ultimate aim of avoiding any shocks that could dent the economy.  Forward guidance, which is a way of guiding expectations, is no longer the FOMC’s main instrument. Yellen had been very transparent on the balance sheet reduction process and presented detailed figures and a precise timeframe, even though the exact end point was not stipulated. But this end point will now be different to what investors had expected, while the Fed’s moves no longer have the same transparency afforded by Yellen: the Fed is keeping its strategy hazy. 

Looking to the Federal Reserve’s decision

If we look at entirely domestic US economic factors, we can find justification for this shift in monetary policy, and the two charts below provide some insight into the matter.

The first uses a labor market indicator based on the JOLTS (see appendix). I have added in periods of monetary tightening as well as recessions, and we can see that in general – apart from 1994 – any halt to the normalization process leads to a swift change in the labor market indicator and that there is a recession 14 months after the end to normalization on average. 

The second chart still shows the monetary policy/recession sequence, but here I have factored in wages as well as core inflation. We can see that wage and core inflation trends have more or less coincided since 1995 if we just look at fluctuations, but the actual levels are systematically different. In other words, a tighter labor market and stronger wage pressure do not necessarily lead to higher inflation. 

If the labor market indicator on the first chart reflects economic activity, then it is at a near high since 1985. Putting a halt to tightening means making a decision to extend the economic cycle at any cost, even if this means a continued highly accommodative policy mix, unless we believe that real interest rates on Fed funds of under 1% – as is currently the case – would be intolerable for the US economy. Yet this would be surprising and would reflect a very fragile state of affairs.  

Last year, Powell attributed tighter monetary policy to an excessively accommodative policy mix created by the White House’s fiscal policy. But this argument has given way to a focus on growth, even if this means allowing imbalances to emerge. 

Even if there is some pressure on the labor market, there is little risk of this being passed on to inflation, as shown by the second chart with the disconnection between wages and inflation. So ultimately there was no need to resort to talk of external shocks to justify the end to normalization. 

Appendix

The chart shows that trends in the difference between the number of job openings (JOLTS) and the jobless total are the same as the difference between numbers answering the Conference Board questions “Are jobs easy to get?” and “Are jobs hard to get?”. The JOLTS series only started in 2000, so I used this coherence to plot the labor market indicator back to 1985 using the Conference Board indicator. I started in 1985 as this was the beginning of the great moderation and is also after the very volatile Paul Volcker period.

JOLTS (Jobs Openings and Labor Turnover Survey) is published by the Bureau of Labor Statistics every month.