The Fed’s Policy Pivot: A New Approach for 2019

February 5, 2019

The Federal Reserve signals a shift in monetary policy, easing concerns over rate hikes amidst slowing economic growth.

In early 2019, financial markets greeted a new tone from the Federal Reserve—a shift away from the aggressive interest rate hikes that had characterised much of 2018. As global growth concerns mounted and the US economy showed signs of slowing, the Fed’s decision to pause its tightening cycle was a welcome development. This shift in policy marks a notable change in direction and raises important questions about the future of monetary policy, inflation, and economic growth.

The backdrop to this pivot is a complex one. 2018 saw the US economy enjoying solid growth, driven by a tax-cut stimulus and a relatively strong labour market. However, signs of a global slowdown began to surface, particularly in Europe and China, and concerns over trade tensions between the US and other major economies started to weigh heavily on business confidence. As the year drew to a close, the Fed’s hawkish stance—indicating multiple rate hikes in the year ahead—became increasingly contentious, particularly among market participants and politicians.

The Fed’s Chairman, Jerome Powell, who took office in February 2018, found himself at the centre of this debate. His initial approach was one of tightening monetary policy, in line with the view that the US economy was robust enough to withstand a higher interest rate environment. The central bank raised rates four times in 2018, a policy designed to curb inflationary pressures and prevent the economy from overheating. Yet by the end of the year, the stock market had experienced significant volatility, and many were questioning whether the Fed’s approach had been too aggressive.

The Shift: A Response to Slowing Growth

Powell’s pivot came at a time when economic indicators were becoming more mixed. While the US labour market remained strong, the global economy was showing signs of strain. Economic growth in Europe had slowed, driven in part by Brexit uncertainty, and China’s economy, which had been a major driver of global growth in recent years, appeared to be decelerating. The US-China trade war, which had escalated through 2018, added to the uncertainty, with both sides imposing tariffs that threatened to disrupt global supply chains.

In the face of these challenges, the Fed began to reassess its policy stance. Powell, in his public statements, acknowledged that the global economic slowdown and trade tensions were factors that could affect the US economy, leading to a reassessment of the need for further rate hikes. The decision to pause the rate hikes was seen as a response to these growing concerns, as the Fed sought to balance the need for stable economic growth with the risks posed by global factors.

The policy shift was significant for several reasons. First, it marked a departure from the tightening cycle that had been in place for much of 2017 and 2018. After years of historically low interest rates following the 2008 financial crisis, the Fed had begun raising rates in 2015 in an attempt to normalise monetary policy. The rate hikes in 2017 and 2018 were seen as a signal that the Fed believed the economy was on solid footing. However, by early 2019, it became clear that the global outlook was far less certain, and the Fed’s pause in rate hikes was an attempt to shield the US economy from external shocks.

The Markets Respond

The financial markets, which had been rattled by the prospect of continued rate hikes, reacted positively to the Fed’s decision. Stock prices rose, bond yields fell, and the US dollar weakened, reflecting a more dovish outlook for monetary policy. The S&P 500, which had experienced a significant correction in the fourth quarter of 2018, rebounded strongly in early 2019. Investors, who had been concerned about the possibility of a recession or a dramatic slowdown in growth, were heartened by the Fed’s shift towards a more accommodative policy.

The response from the markets highlighted the close relationship between Fed policy and investor sentiment. In recent years, central banks have become the focal point of global financial markets, with their policies often dictating the direction of asset prices. The fear of a “policy mistake” by the Fed—where it raises rates too quickly and stifles growth—has been a key concern for investors. The shift in policy in early 2019 alleviated some of these fears, as markets began to price in the possibility of slower but more stable growth.

However, the shift also raised questions about the Fed’s long-term strategy. While the central bank’s decision to pause rate hikes was viewed as prudent given the global economic uncertainty, it also raised concerns about the long-term effects of low interest rates. Critics of the Fed’s monetary policy have long argued that keeping rates too low for too long could lead to financial instability, particularly in asset markets. The prolonged period of cheap credit had already led to concerns about excessive risk-taking in markets such as housing and corporate debt. The Fed’s decision to pause rate hikes further raised concerns that the central bank was unable to fully normalise policy, leaving it with fewer tools to combat future economic downturns.

Inflation: The Elephant in the Room

One of the key factors that influenced the Fed’s decision to ease its policy stance was the low inflation environment. Despite years of strong economic growth, inflation in the US remained below the Fed’s 2% target. In fact, core inflation—stripping out volatile food and energy prices—had been relatively subdued throughout 2018. This lack of inflationary pressure gave the Fed more leeway to adopt a more dovish policy stance without the immediate threat of rising prices.

Yet, this benign inflation environment raises its own set of questions. The Fed’s ability to stimulate inflation through lower interest rates is a key part of its mandate, but what happens if inflation remains stubbornly low despite easy monetary policy? Some economists have argued that the global economy may be experiencing a period of “secular stagnation,” in which demographic trends, technological advancements, and globalisation put downward pressure on inflation. If this theory proves true, the traditional tools of monetary policy may become less effective at stimulating growth and inflation, raising questions about the future of central banking.

The English Literature Parallel: The Age of Uncertainty

In literature, one can draw parallels to the Fed’s pivot by reflecting on the theme of uncertainty and shifting tides. The situation in 2019 mirrors the complexity of Charles Dickens’ “Great Expectations,” in which the protagonist, Pip, must navigate a world filled with unpredictable forces and shifting allegiances. Just as Pip’s life is shaped by forces beyond his control, so too is the US economy influenced by global trends that are difficult to predict or manage.

Dickens’ portrayal of uncertainty in “Great Expectations” reflects the challenges faced by policymakers in today’s world. The Fed’s decision to alter its course amidst a changing global landscape echoes the struggles of characters who must adapt to rapidly shifting circumstances. For policymakers like Jerome Powell, the challenge lies in steering the economy through a period of profound uncertainty, much like Pip must navigate a world full of unpredictable turns. In both cases, the future remains unclear, and decisions must be made with imperfect knowledge of what lies ahead.

The Road Ahead

Looking forward, the question remains: what will the Fed’s approach be in the months and years to come? While the decision to pause rate hikes may have been the right move in the short term, the long-term effects of this policy shift are still uncertain. Will inflation eventually pick up, necessitating higher rates? Will global growth remain sluggish, keeping the Fed in a dovish stance for the foreseeable future? Or will the US economy experience a stronger-than-expected rebound, requiring the Fed to return to tightening?

The Fed’s policy pivot in early 2019 represents a significant moment in the ongoing saga of US monetary policy. As global uncertainties continue to evolve, the Fed’s ability to navigate these challenges and make prudent decisions will be crucial in shaping the future of the US economy.