Why markets shunned the Fed’s dovish stance

On the face of it, the US Federal Reserve’s message to markets last week was extremely positive, with the Fed pledging to keep interest rates at near to zero for the next three years.

In fleshing out its new “average inflation targeting” framework announced just a fortnight earlier, the Federal Open Market Committee is looking to maintain zero rates until inflation has risen to 2 per cent and then stay “moderately” above that level for some time.

This was an unprecedented pledge by the Fed, signalling its commitment to achieving its inflation goals, which should not only have reassured businesses and consumers in the US, but also have positive implications for the GCC and other areas around the world where interest rates are tied to the US. And yet, somehow, it failed to ignite the confidence that was intended – and, in fact, led to more questions than answers.

Not only did the Fed’s message about interest rates imply that the Fed Funds Rate would remain between 0 per cent to 0.25 per cent until the end of 2023, its economic projections also indicated that the US economy will contract by less than it had earlier expected this year and that the unemployment rate will end next year lower than previously projected. What’s not to like?

However, market reaction to the Fed’s statement and forecasts showed that investors did not like the message, selling off immediately following the statement and continuing to the end of the week.

Putting aside whether anybody can accurately predict interest rates in three years’ time, markets are concerned for a number of reasons. For one, they are worried about the lack of details regarding the length of time or the amount of inflation overshoot that would be tolerated before interest rates are raised.

There was also a wide disparity of opinions among FOMC members about the likely path for the economy, and a minority of members appeared to have a low tolerance for inflation overshoots looking for rate hikes despite low inflation.

Indeed, while the FOMC message about the Fed Funds Rate staying where it is for the next three years was clear, the Fed retained its “long-term” projection of 2.5 per cent, leaving the process of how it will ever reach that forecast largely unclear.

In fact, this lack of specificity about how the Fed will meet its inflation goals, and ultimately its long-term interest rate projections, was probably the element most responsible for the negative market reaction.

In particular, the Fed’s statement did not indicate any change to its asset purchase strategy, instead saying that it would continue to purchase Treasury securities and agency-backed securities “at least” at the current pace.

While the Fed’s balance sheet currently stands at $7.1 trillion (Dh26.1tn), it has not been growing for a number of months despite the Fed’s quantitative easing purchases, as these have been offset by reduced repo demand, lower demand for FX swaps and low utilisation of its emergency lending facilities.

This slowing in the pace of the Fed’s balance sheet expansion should have provided an early warning that equities would require support from other liquidity sources, and now prominent economists such as Mohamed El-Erian, the chief economic adviser for Allianz, are asking if stocks are indeed “losing some of their liquidity momentum?”

Others are more blunt, likening the negative market reaction to the FOMC to that of a spoilt child having its toys taken away, highlighting just how addicted equities have become to the provision of central bank liquidity.

Another twist on this is the notion that the more dovish the Fed is, the more markets become concerned that Congress will not agree on a new fiscal relief package. By the same token, the more negatively the markets react, the more this might force Congress to come to the table.

However, given the politics of the election, this might now be less likely with only two months to go, as anything that gives equity markets a boost could be perceived as also helping President Donald Trump’s re-election chances.

As coincidence would have it, the next FOMC meeting is on November 4 and 5, just one day after the election, by which time the Fed and the markets may well have much more on their minds.

Tim Fox is a prominent regional economist and financial market analyst