The Federal Reserve’s Open Market Committee is meeting this week in the context of a weaker data patch in which “hard” measures of economic activity continue to lag better sentiment indicators. As a result, the central bank is widely expected by markets to maintain an unchanged policy stance when the two-day meeting concludes on Wednesday.
Nevertheless, this will be an interesting test of the view, which I and some others have espoused, that the Fed is in the process of shifting operating regimes — from following markets to being more willing to lead them.
Last week’s disappointing reading of 0.7 percent gross domestic product growth for the first quarter, the lowest in three years, added to other data releases (such as retail sales, inflation and autos) suggesting that the U.S. economy — and consumption in particular — is going through a softer economic patch. In previous years, this would have provided the Fed with the excuse to soften its policy signals, assuring markets that monetary policies will remain ultra-stimulative and minimizing the risk of financial asset volatility. Indeed, these are the signals that the European Central Bank reiterated last week when its governing council met. And the ECB did so despite official recognition that, in the case of the euro zone, economic conditions have improved and forward downside risk is lower.
The Fed’s inclination to repeat past practices is countered by three considerations.
– An element of the recent data weakness is likely to be both temporary and reversible.
– The Trump administration has reiterated its intention to pursue a large tax cut that, if approved by Congress (a big if), would most likely lead to a considerably wider budget deficit, at least in the short-run until economic growth and budgetary receipts pick up (especially given the lack of large revenue measures).
– Though even harder to quantify, the Fed is not indifferent to the collateral damage and unintended consequences of prolonged reliance on unconventional monetary policies.
This is not an easy position for the Fed to be in. If officials decide to maintain their policy guidance unchanged, they would risk tightening into an economic slowdown. But if they back away, they would risk reinforcing a market behavior that has already decoupled prices from fundamentals and distorted asset allocation in markets and the economy.
The best, indeed perhaps the only prospect for a “beautiful” normalization of monetary policy — to adapt a term used in another context by Bridgewater’s Ray Dalio — is for the Fed (and other central banks) to be able to transfer a large part of the macroeconomic policy burden — which they have been carrying almost single-handedly — to the institutions and officials that implement fiscal policy and structural reforms. The longer this handoff is delayed yet again, the greater the central banks’ policy dilemma and the larger the risk of a potential policy error.
(This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners)