In a strong economy, the Fed doesn’t want to hold your hand

WHAT’s in a word? When it comes to the Federal Reserve, a lot. The removal of “accommodative” from the Fed’s statement on Wednesday was interpreted as a sign that the Fed is approaching the end of its cycle of interest-rate hikes, and bond yields fell slightly.

But the real story is about rising uncertainty as forward guidance is replaced with an implicit shrug of Fed Chair Jerome Powell’s well-tailored shoulders.

Powell seemed to be going out of his way to confuse investors in his press conference. Having dropped “accommodative” as a description of current monetary policy – something anticipated by many – he went on to say of the change: “It wasn’t because policy’s not accommodative. It is still accommodative.”

Instead, he explained that the word had outlived its usefulness as a signal to the markets of what the Fed was trying to achieve.

The focus on a single word highlights two important market truths: The Fed isn’t focused on supporting the economy, which is doing very well by itself; and the Fed no longer feels such a need to talk down future policy rates in order to get investors to help. The result is that things are likely to get a lot more confusing for markets.

The first is well understood, not least because interest rates are higher than the Fed’s preferred measure of core inflation for the first time since Lehman Brothers collapsed a decade ago. Policy is clearly no longer such a strong support to the economy as it was when interest rates started to rise.

The second is less obvious at first glance. The Fed still publishes its dot plot, setting out where policymakers expect the economy, inflation and interest rates to go. It still explains where it thinks a sustainable unemployment rate is (a median assessment of 4.5%, higher than today) and where interest rates are headed (the median is up to 3.4% by 2020, staying there for a year, before falling back to a long-term level of 3%).

And Fed policymakers frequently make speeches designed to help investors understand how the central bank will react to economic developments.

Yet, Powell has been going out of his way to highlight how little the Fed really knows. On Wednesday, he emphasised the uncertainty in the dot-plot predictions two or three years ahead.

He explained that the Fed doesn’t have a precise understanding of what policy would be accommodative. He said while he hopes that supply-side improvements will follow from the administration’s tax cuts, it was also very uncertain.

And he broached the idea that the Fed’s estimate of the so-called neutral rate, where monetary policy neither supports nor detracts from economic growth, might be raised.

In short: The Fed doesn’t know what will happen, or how it will react.

We should be careful not to go too far. The Fed never really knew what the economy would do, and it might well have breached its previous forward guidance had the economy turned out differently.

After all, the Bank of Canada broke its forward guidance when its economy recovered more quickly than expected, and the Bank of England had to abandon its first attempt at guidance after six months.

Yet, investors have grown used to hand-holding from central banks. Powell’s step back should increase the uncertainty, meaning a wider range of outcomes filters into prices. All else equal, that ought to mean lower stock prices and bond yields.

In some ways this fits what is going on in markets anyway, as both better and muchworse outcomes become obvious possibilities. Trade battles, Brexit, Italy and emerging-market crises are highly visible threats. Indeed, rumours about the Italian budget pushed up the US dollar more against the euro on Thursday morning than the Fed did on Wednesday.

Equally, the tax-cut-driven US growth has been far stronger than expected, and inflation has stayed low, raising the chance that the US helps pull up growth in the rest of the world.

A wider range of outcomes should push investors to take less risk, holding fewer or more defensive stocks and more safe bonds, even if the central forecast remains unchanged. That is the true meaning of no longer being “accommodative.”