Fed Stays on the Sidelines

The Federal Open Market Committee (FOMC) voted unanimously to hold the fed funds rate to its current range of 2.25% to 2.5%. The committee also made a technical adjustment to the interest rate banks pay on excess reserves (IOER), in an effort to ensure that the fed funds rate trades closer to the middle of its range, which is 2.35%. The fed funds rate has drifted a bit above that level in the last several weeks.

The statement that accompanied the decision is more bullish on the labor market than when the FOMC last met in March. This reflects the rebound in job gains for the month of March. The assessment of the economy is still rather tepid, with the Fed noting the sharp slowing in domestic demand that occurred during the first quarter. Consumer spending and investment slowed, while the housing market posted a fifth consecutive quarter of decline.

The most notable change in the statement was the acknowledgement of the weakness in inflation. There is debate within the Fed on whether interest rates should be cut preemptively if core inflation further slows. President Charlie Evans of Chicago has been most vocal on this issue and is among the Fed’s voting members this year. He has argued that the FOMC should consider lowering rates if the core PCE (personal consumption expenditures) inflation measure hovers at the 1.5% threshold for a sustained period. Core PCE hit 1.6% in March.

FOMC members are working to clarify their decision rule and communications regarding inflation. The Fed has stated that the 2% target is symmetric, which Evans defines as meaning that inflation should be above or below the 2% target 50% of the time. The problem is that inflation has not exceeded the target for any meaningful length of time. We also don’t know how much of an overshoot on inflation the Fed would actually allow. My guess is that it would tolerate inflation in the 2.25% range but face substantial political backlash if the rate were allowed to go much higher than that.

The FOMC is still debating how to halt the balance sheet runoff, and what the ultimate composition of its holdings will be. I expect a full announcement on that decision following the June meeting. The Fed has indicated it will curb balance sheet runoff by October 1.

Fed Chairman Jay Powell tried to temper expectations for a preemptive cut in rates tied to inflation. He underscored that the Fed still believes that the low pace of inflation is a transitory phenomenon. He underscored in the question-and-answer period with reporters that he does not see anything that would currently push the Fed to cut or raise rates at this time.

Chairman Powell’s comments were short and well rehearsed. He was careful to keep his cards close to his vest. This serves two purposes: 1) It allows the Fed to pivot again if necessary and 2) to fly below the radar of critics in the White House. The latter is difficult but necessary to preserve the Fed’s credibility. Expect the Fed to move on shifts in the economy, not changes in the political environment, even if a more political appointee were to make it onto the Board of Governors. One vote does not change the course of the Federal Reserve. The larger issue would be the perception of such an appointment in the financial markets. Volatility in financial markets would likely accelerate if one member of the Board consistently dissented with the rest of the Committee.

Bottom Line
The Federal Reserve is walking a tightrope, balancing the current low rate of inflation against the risk of stoking additional asset bubbles. This will leave the Fed firmly on the sidelines this year.

Separately, Powell went out of his way to avoid answering questions about the president’s comments or potential nominees for the Federal Reserve Board, notably Stephen Moore. That is critical for the Fed to maintain independence from the political pressures that are always present in Washington.

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