Fed: Moving Past the Dudley Debacle

Published on August 27, 2019

The political storm ignited by the odd op-ed by former Federal Reserve Bank of New York President William Dudley is absolutely the last thing a beleaguered Federal Reserve Chairman Jerome Powell will want to deal with in the run up to the Federal Open Market Committee September 17-18 meeting.

*** To cut to the chase, and setting aside any deleterious effects of the Dudley-inflicted wounds for a moment, we still expect the FOMC to stay the course at its September meeting with a 25 basis point rate cut as the second of a two-step rate “reset” to bring the policy rate back below a falling short run r*. Although nearly half the Committee, including two voters, are still skeptical of the need for further easing, we think a crucial “insurance” argument will command a majority Committee consensus. Unless the broader data turn truly south in the next few weeks, a 50bp rate cut seems unlikely. ***

*** Fed officials have to date kept to a carefully scripted playbook, noting without judgment the effects of US trade policy in slowing growth by undercutting business confidence and capital spending. But whether the major macro shock is trade, or lax fiscal or regulatory policies of prior eras, the Fed’s reaction function largely remains the same, drawing on signals from data and adjusting policy as deemed necessary to achieve maximum employment and 2% inflation. It is bit tedious to note, but the apolitical institutional culture of the Fed runs deep, and an ill-advised op-ed by a former Fed official is unlikely to change it. ***

That said, however, our sense is that Trump Administration trade policies and political attacks on the Fed are entering into the Fed’s policy calculations, modestly influencing the reaction function, in two ways:

** First, less controversially but complicating the policy decision making process nonetheless, the on/off again negotiating tactics of the Trump trade policies are near impossible to model in terms of their effects on the broader economy or the global blowback into US growth and financial conditions. That, in turn, creates unusually wide confidence bands around the base case rate path, and a more probabilities-based, risk management calculation of costs/benefits in tail risk outcomes factored into the rate path scenarios.

** Second, and more to the point of where we suspect Dudley was so clumsily going, we do think there is a very strongly felt sense across the FOMC of a risk in a so-called “perverse feedback loop,” in which accommodation to counter softening growth or to diminish the risk of recession is instead being diverted into negotiating leverage that ratchets up the very trade threats causing the economic weakness in the first place (see SGH 8/23/19, “Fed: Setting up September”).

** All else being equal, our sense is that the FOMC — particularly in seeking to avoid or deflect an untoward feedback loop in its policy decisions — is adopting a slightly more lagged reaction function than would normally be the case, due to a perceived need for the political cover of clearer evidence in the data of a broadly-based slowdown in the economy to justify further accommodation.

** The effects of these two factors into a modestly changed reaction function are hard to message in the best of times, and the latter is especially difficult to openly discuss or control its thread in the public arena.

** Indeed, we suspect much of the confusion over the Fed’s reaction function in the last year or more — hiking last year when there was no rising inflation, or cutting this summer when there was no substantially falling growth — may have a lot to do with the extent to which rate policy is being driven by lower probability risk calculations and the largely unspoken wariness over being drawn into a supporting role in trade negotiations.

** But where all of this could truly come to a head, moving beyond confusing communications or clumsy op-eds to force a reckoning of sorts for the Fed is a downside shock, whether triggered by trade policy uncertainties or otherwise, that drives the economy and/or the markets southbound in a hurry.

** In such close proximity to the effective lower bound, the Fed’s playbook in those circumstance is to abandon caution and the gingerly-taken insurance rate cuts for full-throated, front-loaded rush of accommodation in rate cuts by 50 or 75 basis points in the first go to maximize the policy punch.

** That is the sort of assertive reaction function the market seems to be pricing, but for the Fed, there is nothing yet on the near horizon to come close to warranting such an aggressive use of its limited monetary firepower. At least not yet. 

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