Several times in the last few years, comments at the press conference that traditionally follows the conclusion of the two-day FOMC meetings have caused significantly more volatility than the prior publication of the central bank’s policy decision and Powell’s written remarks. On Tuesday, the initial market volatility caused by the release of Powell’s opening statement before the beginning of his semiannual congressional testimony was significantly amplified by his subsequent answers to senators’ questions.
The market reactions included a yield spike at the front end of the bond market, with the two-year breaking 5% for the first time since 2007, an across-the-board selloff in stocks, with the S&P 500 Index dropping 1.5%, and an intensification of the inversion of the 2s-10s yield curve, whose spread breached minus 100 basis points.
All three were associated with a significant repricing of what the markets expect the Fed to do at its meeting later this month. Rather than overwhelmingly pricing in an increase of 25 basis points as previously signaled by the Fed, the markets moved the odds in favor of 50 points, which would reverse the downward shift in hikes the central bank prematurely made just a month ago.
Something is not right in all this. The whole point of the increased transparency adopted by the Fed in the last couple of decades is to allow for smooth economic and financial adjustments to policy regimes. Indeed, this is the very essence of forward policy guidance. It is not to undermine the credibility of the world’s most powerful central bank.
Three factors help explain this unfortunate situation.
First, and as detailed in my earlier column arguing that the Fed should not downshift from 50 to 25 basis points on Feb. 1 (as it subsequently did), the central bank seems to lack a comprehensive assessment of policy risks in today’s inherently fluid domestic and global economy.Second, the absence of a strategic medium-term anchoring means that the Fed has become overly data dependent, leading to overshoots.
Third, the August 2020 “new monetary framework” is more appropriate for the pre-2020 world and not that of today and tomorrow — that is, it is designed for the previous paradigm of insufficient aggregate demand and not the reality of insufficient aggregate supply.
The worse thing for policymakers to do is to dismiss Tuesday’s market volatility as noise. There is something more sinister in play. The more this undue volatility occurs, the greater the risk of economic and market accidents — that is a recession caused by what is now three Fed policy mistakes in the past two year and strain to orderly financial market functioning.
Consider the dilemma now facing the Fed: either validate the market move and, in the process, negate in an embarrassing fashion the forward policy guidance provided just a month ago; or stick with that guidance and fall further behind in the battle against inflation.
Both involve yet more reputational risk. Together with the several repeats of undue volatility, they also call for the Fed and political leaders to spend more time on three structural fixes for the Fed that include, as argued last month, “enhancing Fed accountability and requiring it to update its policy framework, as well as follow the example of the Bank of England in structurally inserting outside views in its policy formulation process.”
The alternative of continuing as is increases the challenges to a global economy facing an important green transition, changing globalization and supply chains, geopolitical uncertainties, and a worsening inequality of income, wealth and opportunity.
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