Policy U-Turn

by Peter Jones, CFA
Vice President of Research

On Wednesday, in a widely anticipated event, the Federal Reserve held a press conference and released the “minutes” from their last meeting. The Fed changed their forecast for the path of interest rates from two increases all the way down to … zero. This is a substantial shift. In addition, the Fed indicated that they will end balance sheet runoff in September.

Just six months ago, Chairman Powell said that policy rates “were still well below estimates of the neutral rate.” The neutral rate is the point at which monetary policy neither slows nor stimulates growth. Powell also suggested that the Fed’s balance sheet runoff was “on auto-pilot.” Both equity and bond markets, at least initially, welcomed the news as the Fed’s projection has fallen in-line with market pricing.

The Fed’s U-turn represents a fundamental change in the framework for setting monetary policy. Traditionally, the Fed has served a dual mandate: stable prices and stable employment. In the press conference, Chairman Powell noted that the primary objective of the Federal Reserve is to “sustain the economic expansion.” Conventionally, the Fed has tried to anticipate changes in employment, inflation and growth. Now, the Fed appears to be setting policy based on real-time conditions. One would expect that such a large change in policy would be accompanied by significant changes in growth and inflation outlooks. This was not the case. The Fed only revised these projections very modestly, as seen in the charts below.

Source: Bernstein Research Group

Not only were the changes in these forecasts modest, but the levels were also indicative of an economy that could easily absorb neutral policy rates, if not slightly restrictive rates. For instance, inflation is trending right around the Fed’s target. Economic growth is forecasted to be above 2 percent, slightly above most estimates for long-term potential growth. Even more significant, unemployment is sitting at 3.7 percent versus the targeted rate of 4.3 percent. Does this mean the Fed has reached their estimate of the long-term neutral rate? No. Instead, the Fed’s pivot suggests they are willing to let the economy run hotter for longer in the hopes of sustaining an expansion that is heading toward becoming the longest ever this summer.

In the near term, this 180-degree shift should be supportive for equity prices. At the same time, this pivot introduces risk that the Fed will eventually need to raise interest rates rapidly if continued strong growth and falling unemployment cause a sharp rise in inflationary pressure. 

Week in Review and Our Takeaways

  • Despite a big decline on Friday, stocks were flat on the week

  • Interest rates fell sharply after Chairman Powell’s press conference

  • Policy interest rate increases are unlikely for the balance of the year