Does Jerome Powell’s Fed have a credibility problem?
At its May 1 policy meeting, the Federal Reserve emphasized U.S. economic growth was “solid”, Fed Chairman Powell described low inflation as “transitory,” and said the central bank would remain “patient” before considering any interest rate changes.
A mere six weeks later, the central bank has jettisoned that patient posture, describing economic growth as “moderate” and terming inflation “muted.”
The decidedly easy-money pivot, from holding interest rates steady since January to a likely cut in July, has set the stage for the rate-setting Federal Open Market Committee to “act as appropriate to sustain the expansion.”
What has changed in the intervening month and a half to justify what the market participants now perceive as an almost-certain chance of a cut in interest rates at the end of the July 30-31 gathering?
The Fed under Powell has always argued that it is “data dependent” and changes policy in response to changes to economic data.
The U.S. central bank has managed to keep inflation close to its 2% annual target in recent years although it has persistently been just short of that level. The Fed has also succeeded in meeting its secondary mandate of full employment, with unemployment at 50-year low at 3.6%. So the most important parts of the Fed’s to-do-lists are mostly checked.
So, why the sudden change in posture so soon after the Fed raised rates in December for the fourth time in 2018, marking its ninth rate increase since the end of 2015?
“Powell has a credibility issue because he is facing the most severe political pressure from the President. Cut now and some will inevitably say that the Fed is folding to political pressure,” said Steven Barrow, head of G-10 strategy, at Standard Bank in a recent note.
President Donald Trump has doggedly criticized Powell, who the president handpicked, accusing the central banker of making monetary-policy blunders that POTUS charges has undermined his efforts to juice economic expansion and the stock market.
A day before Wednesday’s Fed decision, Trump said “let’s see what he does,” responding to questions about reports that the president had considered ways to demote Powell.
Still, questions about Fed credibility may be more closely linked to a larger issue: monetary policy alone has its limits, strategists say.
“With [Wednesday’s] Fed meeting we witnessed a confirmed breakdown in central bank narratives over the last year, an utter capitulation to market realities that are forcing central banks to commence a new easing cycle,” said Sven Henrich, lead market strategist at Northman Trader.
“The glorious growth stories everybody told, the tax cuts that were supposed to bring greatness - all nonsense,” Henrich added.
“Instead we’re now stuck with trillion dollar deficits, collapsing yields, and a renewed TINA (there is no alternative) effect as money doesn’t know where to go but stocks, chasing whatever they need to chase. Or, if you don’t want to chase, you can lend money and pay people to borrow from you. It’s all the rage.”
That downbeat view hasn’t restrained stock markets. The U.S. benchmark S&P 500 SPX, -0.13% carved out a fresh intraday high on Friday after notching its first record close since April 30 on Thursday. That historic run-up comes as international investors are struggling to find richer returns on bonds, given more than U.S. $12 trillion government debt globally now offers negative yields. In other words, fixed-income assets are increasingly offering lenders less than their original investments, underpinning a mad dash for higher-yielding assets.
“Cross currents” ahead
“Cross currents” have been buffeting global economies Powell noted, using the term as a coded way to point to the months long trade war between the world’s largest economies, China and the U.S., which has fostered pessimism among businesses and investors. Back in December, Powell said “cross currents have emerged” as policy makers delivered what amounted to a possibly wrong headed interest rate increase.
The European Central Bank and the Bank of Japan, among others, have said further economic stimulus may be need to address the economic slowdown caused by battles over tariffs.
But global economies have been showing signs of strain even before U.S.-led tariff clashes injected a fresh dose of anxiety into the hearts of economists and market participants.
Expectations that the historic decade long U.S. economic expansion may be drawing to a close have been aired since last year and the imposition of import tariffs may only be bringing the business cycle to an end more quickly.
JP Morgan Chase argued in a note that the US-China trade battle has been enormously damaging already and this will appear in economic data and corporate earnings over the coming weeks.
Indeed on Friday, IHS Markit said its flash manufacturing purchasing managers index in June dropped to 50.1 from 50.5 in May, the worst reading since Sept. 2009. Meanwhile the flash services purchasing managers index in June fell to 50.7 from 50.9, the worst reading since March 2016. Purchasing managers’ indexes have become a useful leading indicator of economic activity central banks have found in recent years.
“The latest growth and inflation data, along with U.S.-China trade tensions, provide cover for the Fed to lower rates,” said LPL Financial’s Research Chief Investment Strategist John Lynch. “We don’t believe that current economic conditions alone justify a rate cut, but Fed policy is too tight for a prolonged trade war.”
According to the New York Fed’s recession probability model, there is a 30% probability of a U.S. recession in the next 12 months. The last time that recession odds were the same as they are now was in July 2007, which was just five months before the recession resulting from the financial crisis officially started in December 2007.
Perhaps, it is a recession that Fed and other central bankers aren’t equipped to prevent.
Although inflation has been edging higher it has mostly bedeviled Fed policy makers here and abroad.
Former Fed Chief Alan Greenspan in March told attendees at a Wharton Business School discussion that the Fed has a “problem measuring inflation.”
The central bank has been convinced that inflation would hew to its 2% annual target this year, using its preferred personal-consumption expenditure gauge. This week though the Fed lower its forecast for 2019 to 1.5% from 1.8%.
The curious state of inflation even as the labor market remains healthy, perhaps, is a further evidence of the Fed’s limitations, adding to some critics views that it may not be best equipped to negotiate a soft landing if the economy and the highflying market stall out.
Read: Fed’s errant estimates of inflation, interest rates show folly of long-term forecasts