The full surrender of the Fed is a fact and the market is celebrating the victory. The Fed's remarkable U-turn, which began in November 2018, was executed earlier this week. The era of interest rate hikes in the United States seems to be finally coming to an end.
In 2018, the Fed raised rates 4 times. After the financial markets the first tolerated, the bank became overconfident. He indicated that he would raise the world's most important interest rate another 2019 times in 3 and that he would continue to do so in 2020. However, the market thought that was going too far. The result? A sharp drop in stock prices.
Because of that decline, the Fed did not know how quickly to announce that the bank is changing its monetary policy. While the discussion a few months ago was about 3 or 4 interest rate increases, in November the question was whether this would happen at all.
Fed changes course
Falling stock prices threaten to disrupt economic growth. On the one hand through the negative effect on confidence and on the other hand through the risk of financial instability. The Fed's pivot in the last 2 months of 2018 removed much, but not all, of the unrest and uncertainty in the markets. And so the bank completed that turn completely on Thursday, January 31.
De conclusion From last week's meeting, in my opinion, the Fed has switched from the term 'interest rate increases unless' to 'interest rate increases if'. While until recently the bank still had to be convinced to stop raising interest rates, it now needs to be convinced to raise the country's and the world's most important interest rate.
That seems like a linguistic nitpick, but is actually something big and important. It is as if the burden of proof in the legal system is reversed: you are only innocent if you prove to the authorities that you are not guilty.
Chance of interest rate cuts
It may even seem that interest rate cuts cannot be ruled out this year. Jerome Powell, the chairman of the Fed, indicated that a change in interest rates could also be a reduction. This is because the bank's policy is not on autopilot, but depends on economic developments.
When would the Fed resume the original interest rate? Well, at least not if inflation starts to climb. Powell said that a rise in inflation would be a big part of the need for raising rates. He added that this is not the only reason, but it is a big reason.
If you read those comments carefully again, he is basically saying that if inflation in the US rises, it does not provide sufficient reason to raise interest rates. If the economic outlook were to deteriorate, the bank would at least keep the interest rate unchanged. And if financial conditions deteriorate (falling share prices and rising interest rates), an interest rate cut is certainly possible.
In the above situations, not only interest rate cuts are to be expected, as it could also slow down or even stop the pace of reduction of the bank's balance sheet. That is the interpretation I have made of Powell's statement: "We will use all tools, including the pace of balance sheet normalization."
Repetition of the past
There is also a historical fact that, in my opinion, makes the chance of a resumption of the cycle of interest rate increases small. In the past, the bank almost never resumed this cycle after taking a break; That happened once, in the mid-1s. However, then the economy grew faster and labor productivity rose sharply. In 90, growth will slow down and the increase in productivity will be miserable.
“Common sense, risk management and a case for caution. We have to wait until the picture becomes clearer,” Powell said. In my view, this can best be translated as saying that the Fed will only raise interest rates this year if the economic prospects improve, inflation starts rising again and financial conditions do not deteriorate.
Watching cat out of the tree
The bank is currently watching the cat from the tree. Combined with the overused word 'patience', that watching can become a long affair. The removal of the need for further interest rate increases from the committee's statement is more than a cosmetic change. And Powell expresses himself euphemistically when he says that the need to raise interest rates further has decreased. What he says casually is that there is a very good chance that this period of interest rate increases has come to an end.
We will discuss the Fed's prospects for 2019 and the coming years, and the same with regard to the ECB, and its consequences for interest rates and the value of the euro, in more detail in Masterclass Financing and Capital Markets.