The Fed Open Market Committee (FOMC) met on Tuesday and Wednesday this week and as expected, there was no interest rate hike. The policy statement said the Fed would continue to be “patient” regarding any future interest rate hikes this year. In his post-meeting press conference, Chairman Jerome Powell said the Fed plans to end its balance sheet reduction in September.

The bigger question I want to address today is why the FOMC went from being hawkish in December to dovish in January and since. [In case you’re not familiar with these terms, hawkish means the Fed is inclined to raise interest rates, whereas dovish means the Fed is inclined to leave rates steady or lower them.]

When the FOMC met in December last year, it hiked the Fed Funds rate to 2.25-2.5% and signaled that it would raise the benchmark rate at least another three times, to 3%-3.25%, before stopping. It also signaled that it would continue to reduce its huge balance sheet of Treasury bonds and mortgage-backed securities by up to $50 billion per month.

But just six weeks later, at the FOMC meeting in late January, the Fed announced it would pause its rate hikes for the foreseeable future and suspend its balance sheet unwinding sometime this year. Very little guidance was offered to explain this significant change in policy. So, the question is: What caused the abrupt about-face? Several things, actually.

The first thing I would point out is President Trump’s appointment late last year of Richard Clarida as Vice Chairman of the Federal Reserve and a voting member of the FOMC. Mr. Clarida is considered to be more dovish on monetary policy, as is Chairman Powell. As a result of Clarida’s addition, the FOMC now tilts slightly more to the dovish side. Before Clarida came in, the hawks on the FOMC kept Powell’s dovish tendencies in check. 

I believe this was a big key to the major policy change in January.

Several other factors also contributed to the decision to change policy. First, the Fed saw a significant tightening in the credit markets late last year, which was exacerbated by the rising US dollar. The long government shutdown was also a factor.

Second, in the latter half of 2018, US core inflation unexpectedly stopped rising toward the Fed’s 2% target and even started falling slightly. With inflation expectations weakening, the Fed had to reconsider its rate-hike plan, which was based on the belief that structurally low unemployment would drive inflation above 2%. It didn’t.

Third, the Fed was concerned about President Trump’s escalating trade wars and slowing growth prospects in Europe, China, Japan, and emerging markets. This raised concerns about our own growth outlook here in the US. For all these reasons, the Fed decided to change policy.

These mitigating factors and others have more Fed-watchers suggesting that the FOMC will not raise interest rates at all this year. What a switch! While we may not see another rate hike this year, we could have one in 2020 if the economy remains strong.

A lot depends on whether inflation remains tame (ie – 2% or below) and if the US economy stays vibrant. That remains to be seen, of course. But if inflation rises above the Fed’s target of 2%, we could very well see the FOMC change policy again to a more hawkish stance.

Why the Fed’s Current Inflation Target is 2% – It Just Is

I’ve been writing about the Fed for over 30 years. One question I have been asked over and over is: How does the Fed arrive at its inflation target, which plays such an important role in setting interest rate policy?

The Fed employs dozens of economists and even more staffers that assist them. They have numerous sophisticated economic models which they employ to guide their policy decisions. The question is, how accurate are they? My opinion is, not very! But that’s another story.

The Fed says it has a “dual mandate” of maximum employment (good economy) and stable prices (low inflation). The Fed has used 2% as its inflation target since the mid-1990s but didn’t state that publicly until 2012 when it decided to be more transparent.

The 2% inflation target is based on the Personal Consumption Expenditures Index (PCE), rather than the Consumer Price Index. The headline PCE Index the Fed uses includes food and energy prices, which the Fed believes is a better measure of what families actually spend. I agree.

As you can see above, the PCE Index has been running at or below the Fed’s 2% target for the last decade. We have enjoyed a long period of low inflation, which is unusual given the strong economy. There are many reasons for this which are too detailed to get into today. The point is, the Fed has adopted 2% as its inflation target since that has been about the average over the last couple of decades.

I’ll leave it there for today.