When will the Fed pause its tightening of policy?

If you’ve been reading my most recent posts on US monetary policy, the sense you would have been getting is that the Fed is shifting away from its tightening bias. And the main reason it’s unclear what this means in terms of actual policy, is that the Fed’s famous data dependency mandates this uncertainty.

The Fed’s problem

Where this comes unstuck is in how the Fed has communicated its forward guidance. The FOMC has put forward a summary of economic projections that shows the Fed raising rates in 2019 and 2020 even as the economy is slowing down. And as Tim Duy noted recently, that effectively means the Fed’s economic “outlook is fundamentally hawkish as it describes policy as continuing to tighten even as growth decelerates.”

Indeed. So, now that this deceleration is upon us, what does the Fed do? One possibility is that it revises its guidance. And while I believe we will eventually get there, doing so without a clear change in the course of the economy would be damaging to the Fed’s credibility. It would reduce the believability of the Fed’s forward guidance. So, I believe the Fed is loath to go there.

Another possibility is that the Fed hones in on material changes in the outlook – like the tightening of financial conditions, the slowing in the global economy, or a slowing in the property sector  — that are not a part of its economic forecasts. Remember, the Fed already has a forecast of growth, unemployment and inflation. And unless, the economy does worse than its projections, the Fed has no reason to deviate from its forward guidance premised on those variables — except that it lost its nerve. So, it makes sense to predicate a downshift in the rate hike timetable on other important factors that they have not forecast.

Timing of the downshift

The deceleration in the Fed’s rate hike timetable is not a foregone conclusion. Indeed, the Fed’s policy choices are data dependent, as it professes. So, if the numbers look good, the Fed will not downshift. It might even be forced to upshift (though I doubt that outcome is realistic). But, the credit sector is showing clear signs of financial tightening. And I believe the Fed will react to that.

The macro data are still good though, both the data coming out about to present and forward-looking indicators about the near-term. And so that means we will get a rate hike when the Fed meets next week. The question, then, becomes, how and when will the Fed change guidance in order to hedge toward a pause. I don’t think anyone knows the answer to that question. My bet is that we won’t see any guidance language changes next week. But, we could do in January if the data are below par.

If the holiday data are above par, as I anticipate, then I don’t see any reason to expect the Fed to change forward guidance in January either. At that point, the March rate hike will become a near lock. And we will be moving toward a point where markets will have been caught out by the Fed’s hawkishness, just as they were at the beginning of 2018.

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