Markets rallied after US Federal Reserve Chairman Jerome Powell indicated on November 30 that the world’s most powerful central bank would now slow the pace of rate hikes. The fact that this comment was balanced by warnings about an uncertain outlook for inflation and policy proved irrelevant to the markets. He only heard the good news. This is far from a relief for the Fed which still needs the markets to help ease high inflation. It also does not help counter the political pressures it faces by failing to respond to inflation in time, nor the risks of plunging the economy into recession.
By imagining the following hypothetical conversation between Powell and the financial markets, you can get a good feel for two things: why the Fed faces a difficult communication challenge that is consequential for the well-being of the US and other economies, and Why faces an acute political challenge.
POWELL: Did you hear what I said at the Brookings Institution on Wednesday?
Market: We heard one thing more than anything else. You are definitely going to slow down the rate hike starting this month. You were completely unequivocal in saying that “the time may come to ease the pace of rate hikes at the December meeting.” That’s dynamite!
POWELL: But there was more to what I said. I have given many warnings about what is going to happen next and therefore, I have pointed to a longer rise in interest rates.
Market: Maybe. But you also mentioned that you’re worried about tightening too much. You haven’t done this in a long time. And it’s not just you. You explicitly said it was your FOMC colleague as well.
Powell: Not so fast. You are very one sided. Did you hear me say that there was “more ground to cover” to fight inflation and that history is clear about “prematurely lax policy”.
MARKET: We noticed that you told us prior to the publication of Friday’s jobs report that you are downshifting on the rate hike. You clearly feel strongly about this.
Powell: Wait…
Markets: We also saw what you failed to say. You made no effort against the drastic easing of our financial conditions in recent weeks. With that, we’ve got an even faster green light from you to loosen them even further, raising stocks by 2% to 4% on your comments, depreciating the dollar and raising bond yields by an average of some 10 basis points. so that the 10-year Treasury is now about 50 basis points below where it was a month ago. Surely, that’s what you expected. Heavy loosening of financial conditions.
Powell: No. I expected you to hear my full comment, not just what you wanted to hear.
Market: Really? But we’ve been conditioned for years to expect strong support from the Fed in the form of rates and liquidity. And this is where you indicated that we’re starting to go back, especially now that inflation is not an issue. Just look at your own guesses!
Powell: Wait, wait, wait. It is too early to declare victory over inflation. Indeed, I said flatly on Wednesday that we would need “much more evidence” before we can be comfortable that the inflation problem is behind us. I also said that our inflation forecasts have been proved wrong time and again.
Markets: But both real and forward indicators of inflation point uniformly to the downside, and not just in the US.
POWELL: Coming down on inflation is one thing. Returning to our 2% target is another matter. The problem of inflation is not behind us. Then there’s the weak growth outlook. It certainly matters for earnings and stock prices.
Marketer: Oh, we heard you say something about that. But you have, at least implicitly, repeatedly reinforced the market consensus that the downturn, if it did materialize, would be short and shallow. This means that we should simply “see it.”
POWELL: I wish politicians would see it too. I don’t think they like it when I predict below-trend growth and high unemployment. They think the Fed can somehow get away with it.
Bazaar: Well, we sympathize with them.
Powell: What do you mean? Surely, you are aware that overcoming the threat of inflation is vital for high, sustainable and inclusive growth which is also in line with the fight against worrisome climate change.
Markets: Yes, but wouldn’t we be better off in most cases if the Fed hadn’t misrepresented inflation as ‘fleeting’ so badly and for so long; whether the Fed had finally ‘retired’ from its terminology to ‘temporarily’ tighten the policy; And wasn’t it forced into a record four consecutive 75-basis-point rate hikes?
Powell: Sorry. It’s almost time for our blackout period before our December policy meeting.
Mohammed A. El-Arian is the President of Queen’s College, Cambridge and the former Chief Executive Officer of PIMCO.
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