The Fed relents

Matthew Peter, Chief Economist 

Before Christmas, as equities plumbed their lowest levels of 2018, I wrote that the US Federal Reserve (Fed) had risked turning an orderly equity correction into a disorderly equity bear market with its stubborn refusal to reassure markets that the cycle of monetary policy tightening wasn’t on auto pilot (The Fed is the Christmas Grinch). This week, the Fed formally acknowledged the risks to financial conditions by following dogmatically a policy of tightening, reassuring markets that they would be attune to current economic conditions and that they all levers of policy, including the sell down of assets on their balance sheet, were flexible; meaning no auto pilots.

In particular, the FOMC dropped its forward guidance of “further gradual [rate] increases” that was outlined at its December meeting, instead noting that “in light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate…” The FOMC also sounded more dovish on its assessment of inflation pressures and inflation expectations, removed its characterisation of the risks as “roughly balanced” suggesting they now view the risks as to the downside and highlighted a more flexible approach to reducing the size of its balance sheet.

Regarding the latter, the Fed highlighted that it “is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.” In addition, the Fed stated that it “would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.” The Fed also appears to be moving closer to the end of its balance sheet reduction program, with Chair Powell noting that “the normalization of the size of the portfolio will be completed sooner, and with a larger balance sheet, than in previous estimates” and that plans would be finalised at upcoming meetings.

Other central banks have also been more circumspect over recent weeks. The European Central Bank (ECB) has acknowledged the recent weakness in the euro area economy, while also shifting the balance of risks to the downside. While the ECB appears to be in a wait-and-see mode until their March meeting, they do appear more willing to announce further liquidity operations to smooth the impact of expiring TLTRO roll-downs and potentially push-out their forward guidance should incoming data continue to disappoint. Furthermore, the People’s Bank of China has stepped up its policy easing to help support the economy, with 100 basis points of RRR cuts and targeted medium-term liquidity injections in January.

For those who argued that monetary policy was a spent force, the reaction of financial markets to the turnaround in central banks’ policy stances has been chastening. Since its low point on Christmas Eve, the S&P 500 has rallied 15% on the back of a series of dovish policy statements by the Fed, which culminated in the FOMC meeting this week. Outside the US, the MSCI World Index (local currency) has rallied by 12%. Following the post-Christmas rallies, the S&P 500 and MSCI World remain around 8% below their September 2018 high water marks, which in our opinion brings these markets closer in line with their fair values than the levels seen in either September or late December of 2018.

Some commentators worry about the so-called ‘Fed put’, whereby the Fed underpins equity and other risk asset valuations through easing monetary policy, which can lead to excessive risk taking by investors. We agree that central banks should not use monetary policy to fine tune asset valuations. However, we disagree that monetary policy should not be used to arrest a slide in asset prices that pushes valuations to substantially below fair-value levels and threatens financial and economic stability.

As the GFC showed, monetary policy is effective in arresting an uncontrolled slide in financial conditions brought about by a sudden spike in risk premia following a collapse in market sentiment. With so many downside risks currently facing the global economy, it is prudent of central banks to ensure the stability of financial markets.


Table 1: Financial market movements, 24 – 31 January 2019

Equity index



10-yr government bond



Foreign exchange



S&P 500





-8.6 bps

US Dollar Index (DXY)



Nikkei 225





-0.6 bps




FTSE 100





-4.6 bps









-3.1 bps




S&P/ASX 200





-2.9 bps




Source: Bloomberg


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