Editorials

The U.S. Federal Reserve makes a U-turn

The U.S. Federal Reserve reversed course this week, holding interest rates steady and declaring that the economic outlook demanded more “patience” from policymakers. This is a stark contrast with the Fed’s sentiment at its last meeting; then, it raised interest rates and signaled that more were likely given a strong global economy. This week’s decision is an accurate reflection of changing economic conditions and the Fed’s flexibility is to be applauded. That should not go too far, however: Overall economic conditions, and not market sentiment, should be the Fed’s guiding light. Some fear that is not the case.

When the Fed last met six weeks ago, it had a bullish take on the global outlook. It agreed to a quarter-point rise in interest rates and signaled that at least two more increases were to be expected in 2019 given those economic fundamentals. While that triggered complaints from markets and U.S. President Donald Trump, the decision made sense: The economy was running strong and there were few headwinds. Raising rates, and continuing to unwind the holdings on its massive $4 trillion balance sheet, gave the Fed room to intervene if conditions deteriorate.

In the intervening time, conditions have changed, and the Fed has indicated it is prepared to respond to them. Speaking after this week’s meeting, Fed Chairman Jerome Powell explained that the economy remained strong — an optimistic assessment after the historical five-week government shutdown and the continuing political gridlock that produced it — but other “cross currents” were concerning. He pointed to slower growth in Europe and China, uncertainty created by the trade war between the United States and China, the world’s two largest economies, and Brexit. Combined with low inflation at home, those factors “weakened somewhat” the case for raising rates and demanded a “wait and see” approach.

Powell believes the Fed should be “patient in evaluating the outlook before making any future adjustment to policy,” a commonsense approach. He added that he is waiting to see signs of inflation before raising rates again, and currently, prices have risen just 1.8 percent in the past year, below the target level of 2 percent annual growth.

Markets were delighted by the decision, with the Dow Jones Industrial Average jumping nearly 435 points and crossing the 25,000 level. There is some concern that the Fed has become overly sensitive to market movements in the wake of its announcements: After its December decision to raise rates and the indication that more increases might be in the works in 2019, the Dow fell over 450 points. Market volatility is troubling, but the Fed must base its actions on the entire economic picture, not one particular perspective.

There is also concern about Trump’s criticism of the decision to raise rates. The president views the Dow as a proxy for the success of his economic policies, and he has not been shy about letting Powell know his displeasure. Powell pushed back against charges that the Fed has been overly sensitive to criticism, noting that his only motivation is “to do the right thing for the economy and for the American people,” adding that while he and his colleagues might make mistakes, “we’re not going to make mistakes of character or integrity.”

Bank of Japan Deputy Gov. Masayoshi Amamiya applauded the move, noting that any decision keeping the U.S. economy strong is good for Japan, although the weakening of the dollar against the yen that followed is an indication that such moves are not unalloyed. At its last meeting, two weeks ago, the BOJ’s Policy Board decided to hold interest rates steady even though inflation remains well below the 2 percent target and committee members could see the same headwinds that motivated the Fed to act. The problem for Japan is that with interest rates already effectively negative and its own balance sheet bloated, there is little room to maneuver if economic conditions deteriorate. That capacity to counter negative conditions may be tested this year when the consumption tax increase goes into effect in October and if the U.S.-China trade war continues.

Policy reversals by the Fed are not without precedent. At least twice in the last decade, it has made profound shifts in its stance. Both times, they reflected changes in the broader economic outlook. That realism, rather than any ideological fundamentalism or browbeating by the president or the market, must guide Fed thinking. This week’s decision to remain patient is a promising indicator of Powell’s, and the Fed’s, good sense.

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