Janus Henderson: Fed hikes in era of pragmatism over dogma

As the market expected, and fully priced, the US Federal Reserve (Fed) raised interest rates on 26 September to take short-term rates above 2%. In addition the Federal Open Markets Committee (FOMC) removed the reference to policy being accommodative within their statement; something that had been expected over the next few meetings as rates rise steadily towards the FOMC’s estimate of neutral rates. The early removal was seen by the markets as a dovish surprise at the margin.

A preference for pragmatism over economic dogma

The attentive Fed watcher will have noted that the Federal Reserve under Chairman Jerome Powell is a different beast to what we saw from previous Fed chairs like Bernanke and Yellen. While the differences are slight, they are important. Not only is Powell’s background different (he is the first non-economist to chair the FOMC for 40 years), his approach is different, and refreshingly so.

Powell communicates in a clear and straightforward fashion, preferring pragmatism to economic dogma. Importantly, he is not afraid to tell the world that when the Fed makes a forecast, especially far out into the future, there is a high degree of uncertainty around that forecast. Subsequently, those paying attention to previous speeches by the chairman will have noted that Powell is trying to move away from providing a false sense of security to markets in the precision of the Fed’s forecasts and changes to the language. Future changes to how the Fed communicates need to be interpreted in this way.

Subsequently, we would not describe the Fed’s decision to drop the reference to accommodative policy as an indication that they think they are close to neutral and, therefore, perhaps the end of the cycle. Instead one should interpret it as the Fed saying they don’t really know where neutral is — it could be higher than thought or lower than thought — and they will act in accordance to economic developments as they occur.

The future rarely conforms to expectations

Currently, economic data is strong and the US economy is flying high, so the Fed will continue to raise rates. However, much of this strength may be attributed to the stimulus implemented this year, which is expected to fade in the second half of 2019. In reality no one really knows and the Fed agrees.

For the market this is important. We had four hikes priced in prior to this meeting over the next year and a half, which is not far off but below the median projection of the FOMC. Some have argued that this means the market is under-pricing the Fed’s likely rate hike path. However, the point that Powell makes regularly, and that market participants learn almost daily, is that the future rarely conforms to expectations. Thus, any expectation of future events should always be handicapped to reflect this (aggressively, if you are looking more than a year out). 

Yields are lower following the Fed meeting yesterday but rather than the Fed surprising dovishly, perhaps the market is merely taking some of the certainty about future Fed tightening out of its forecast. In a world of divergent growth, trade wars and geopolitical stresses and strains, much can happen that may move the Fed away from its slow and steady rate path projection.

This is Powell’s era

We see Powell’s approach to communication as an important break from the previous Fed chairs’ communications of the post-crisis era. Certainty in terms of forecasts, even those of a central bank, deserve to be treated with caution and Powell is telling us so.

The days of forward guidance and reliance on economic projections to drive conviction in markets, as experienced under Bernanke and then Yellen, is coming to an end. This is Powell’s era and we would do well to take note.