Economic Update


Federal Reserve Takes a Dovish Turn

U.S. President Donald Trump may be feeling a sense of relief right now. The government has re-opened after a five-week shutdown – also reducing the opportunities for conflict with the tough House Speaker Nancy Pelosi -- and the Federal Reserve has taken a more dovish turn.

The Fed has changed its tone regarding monetary policy. At the Federal Open Market Committee’s meeting at the end of January, the Fed voted in favour of maintaining the target range for the federal funds rate at 2.25-2.5%. Trump has previously criticized the Fed for raising rates too quickly.

In a statement following the meeting, the central bank said that it would now “be patient” when adjusting the interest rates. It also dropped its previous remark that “some further gradual increases” in interest rates will be needed. Economic growth was described as “solid” in January’s statement instead of the previously quoted “strong.”

Regarding the scaling down of the Fed’s balance sheet, it said that it was willing to adjust “any of the details for completing balance sheet normalization in light of economic and financial developments.”

The Fed began, in October 2017, to unwind its US$4.5 trillion balance sheet, which had ballooned due to quantitative easing implemented after the global financial crisis. The unwinding process started with a reduction of US$10 billion per month and accelerated to US$50 billion per month currently. (Figure 1)

The changes in language are the strongest signals by far that the Fed is likely to put further interest rate hikes on hold in the first quarter, and that Chairman Jerome Powell will not risk damaging the economy by raising interest rates too fast.

This wait-and-see approach taken by the Fed is understandable, as waiting a bit longer is unlikely to do any serious harm.

That being said, the overall picture of the U.S. economy is still in good shape, notwithstanding the recent volatility in the stock market.

Although the partial government shutdown in the U.S. will have a negative impact on the economy in the first quarter, the impact should be limited. The Congressional Budget Office estimated that the level of GDP for the full year of 2019 will be only 0.02% smaller than it would have been otherwise.

As for the China-U.S. trade war, some kind of deal to address at least the trade imbalance issue is not out of reach by the deadline of 1 March. Both sides are facing more economic pressure to cut a deal, compared to a few months ago.

So why has the Fed made this U-turn on rate rises? In the absence of a major change in economic fundamentals, it does look a bit odd. Some say that the Fed’s decisions have become more unpredictable. But we consider that the latest U-turn means just the opposite, and reinforces our belief that maintaining asset market stability is actually an unofficial mandate of the central bank. Accordingly, the stock market’s performance might in the future do a better job of predicting interest rate directions than inflation and employment data.


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