Bloomberg
On the surface, it’s hard to argue that the Federal Reserve’s monetary policy meeting that concluded Wednesday was anything but a success. Although the central bank raised its key interest rate by half a percentage point in the biggest move since 2000 and Chair Jerome Powell signaled that at least two more similar increases are coming at the June and July meetings, the stock market rose the most in two years and the bond market rallied, pushing yields lower. But those moves highlight a potential strategic mistake by Powell.
The reason investors rejoiced was because Powell said at his press conference after the decision that policy makers weren’t actively considering raising interest rates by three-quarters of a percentage point to help rein in inflation, which is at a 40-year high. By some measures, futures traders were pricing in a 75% chance of such a move at the next policy meeting in mid-June. So Powell’s unexpected “dovishness” was a welcome surprise to investors.It’s unclear why Powell decided to tamp down forecasts of a 75-basis-point increase. Perhaps he didn’t want to signal that the Fed is panicking over its inability to tame inflation and that the only way to do so is by raising rates in ever bigger increments. But by taking such a move off the table so explicitly, the Fed risks provoking the opposite of what it wants to accomplish, which is to tighten financial conditions through the demand side of the economy. As Powell told CNBC in a recent interview, “We need our policy to transmit through the real economy, and it does so through financial conditions, which means we tighten policy, broader financial conditions will also be less accommodative.”
But instead of tightening financial conditions, the big rally in stocks after the Fed’s decision only underpins the notion that the central bank has the markets’ back, causing financial conditions to ease and promoting more risk-taking. And the rally in bonds should cool rapidly rising consumer borrowing rates, such as those for mortgages. The point is, investors have a greater tendency to take risks when they know what the Fed will do, when it will do it and by how much. If Powell had only left open the option for a 75-basis-point increase, he could have kept markets guessing and contributed to the goal of tighter financial conditions. BNY Mellon macro strategist John Velis summed it up nicely in note to clients:
We wonder why Chair Powell chose to be so prescriptive. There would have been little cost to not ruling out 75bp moves and the advantage of preserving the central bank’s policy options going forward. Keeping the market somewhat in the dark (without being unnecessarily opaque) would have probably been beneficial, while at the same time keeping investors on their toes as we head deeper into the year.
Federal Open Market Committee members know the power of rhetoric in carrying out policy. Federal Reserve Bank of St. Louis President James Bullard delivered a presentation for a Princeton University webinar last month in which he argued that the Fed may not be as far behind the curve as pessimists assumed. He noted that standard monetary policy rules make it look as if the federal funds target range was far too low for the current inflationary environment. However, he argued:
Credible forward guidance means market interest rates have increased substantially in advance of tangible Fed action. This provides another definition of “behind the curve,” and the Fed is not as far behind based on this definition.
The market reaction this week was similar to the one after Powell’s press conference following the Fed’s decision in mid-March to raise rates by a quarter of a percentage point, the first increase since December 2018. Then, as now, Powell’s tone sent stocks surging higher, but at least bond yields behaved. It took weeks of public jawboning by Fed officials get financial conditions to tighten. This time was worse because bonds rallied as well.
To be sure, it’s laudable that Powell values transparency. Modern central banks succeed when they maintain the public’s trust, and that’s best done through clear and open communication. But Powell needs a large and varied arsenal to tackle inflation, and he didn't need to take anything off the table on Wednesday. His central bank colleagues may need to come out more hawkish to make up for Powell’s perceived dovishness, starting Friday with public remarks by Bullard, Fed Governor Christopher Waller and Federal Reserve Bank of New York President John Williams.
It’s possible that the market misread Powell. He may have played down jumbo rate increases, but Powell also said he was willing to act like his hero Paul Volcker — at the risk of pushing the economy into recession — if that’s what it takes to restore price stability. That’s a powerfully hawkish statement, and it ultimately says more about where the Fed may end up rather than his apparent aversion to 75-basis-point moves. It’s not the pace so much as the destination that matters. Perhaps markets started to grasp that Thursday morning, with stocks giving up much of Wednesday’s rally and bond yields drifting higher again.
It’s also understandable if Powell wants to move carefully as the Fed starts to unwind an unprecedented amount of quantitative easing by allowing maturing securities on its $9 trillion balance sheet to run off. But it wouldn’t hurt to keep the market guessing. In the three-dimensional chess game that is central bank forward guidance, Powell didn’t need to telegraph this particular move.
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