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And the Fed pivot, born of volatility, missteps, and new economic reality



WASHINGTON (Reuters) – The Federal Reserve's promise in January is "patient" about further interest rate hikes, putting a three-year-long process of tightening policy on hold, calmed markets after weeks of turmoil that wiped out trillions of dollars of household wealth.

FILE PHOTO: A screen shows the headlines that the US Federal Reserve raised rates as trader works at a post on the floor of the New York Stock Exchange (NYSE) in New York, US, December 19, 2018. REUTERS / Brendan McDermid / File Photo

But interviews with more Half a dozen policymakers and others close to the process suggest it also marked a more fundamental shift that could define President Jerome Powell's tenure as the point where the Fed first fully embraced the world of persistently weak inflation, perennially slower growth and permanently lower interest rates.

Along with Powell's public comments, Fed minutes and other documents, the picture emerges from a central bank edging toward a period of potentially difficult change as it reviews how to do business in light of that new reality. One question, for example, is whether to make crisis-fighting policies a part of the routine toolkit. Another is whether to try to prepare the public to accept higher inflation from time to time.

Policymakers have been debating for years how well traditional central banking fits into a world transformed by global financial crisis a decade ago. But it was a brief Oct. 3 remark by Powell that set off the chain of events that helped settle the matter.

"We are a long way from neutral now, probably," Powell said at a Washington think tank event, referring to a level of interest rates that neither cool nor boost the economy.

Though Powell was effectively summing up what the Fed had just concluded in his Sept. 25-26 policy meeting, when it raised rates amid stronger than expected US growth, his characterization touched a nerve.

Investors dumped stocks and bonds, fearing the Fed aimed to drive rates higher than they felt the economy could withstand.

It was the beginning of weeks of volatility that led the Fed to recalibrate its message, with more than one misstep along the way.

In doing so, the central bank went beyond fine-tuning its language or adjusting to changing conditions. Interviews with officials as well as analysis of Fed minutes and policymakers' public statements suggest the emergence of a long-elusive consensus that interest rates would probably never return to pre-crisis levels, and that once established relationships such as inflation rising when unemployment fell , no longer worked.

Concerns that years of solid economic growth and falling unemployment would inevitably rekindle inflation or threaten financial stability have been a staple of Fed debates, but had largely disappeared by Fed's Dec. 18-19 meeting, according to a review of Fed meeting minutes and official public statements.

GRAPHIC – How the Fed's meeting minutes reflected changing views on interest rates: tmsnrt.rs/2TX9fC0

It was a conclusion hiding in plain sight. After a year when the Trump administration pumped around $ 1.5 trillion of tax cuts and public spending into a full employment economy, the Fed in 2018 would miss its 2 percent inflation target again.

"I hate to say we were right," Dallas Federal Reserve President Robert Kaplan told reporters on Jan. 15 in Dallas. "But we have been warning for quite some time that … the structure of the economy has changed dramatically."

Technological innovation, globalization, and the Fed's commitment to its inflation target all held down, and "those forces are powerful and they are accelerating, "he said.

His arguments echoed those made by St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari. New Fed Vice President Richard Clarida and Governor Lael Brainard have flagged similar issues.

Later in January, the Fed's policy meeting was a jettison of any further rises and cited "mutated inflation" among the reasons, largely aligning the Fed with the prevailing sentiment among investors who saw conditions weakening.

At first, it was investors who seemed overreacted to Powell's "long way from neutral" remark in early October.

Global markets have absorbed nearly two years of quarterly Fed rate increases in stride, but yields on U.S. 10-year treasury bonds spiked and a tenth of a percentage point that day and stocks started a slide that wiped out 10 percent of the S & P 500's value by late November.

If sustained, it was the type of environment, with asset values ​​falling and borrowing conditions tightening, which could hurt Main Street economy and not just the investor class.

The initial response from Powell and others at the Fed was that the U.S. economy remained strong, and that was not the central bank's job to collapse Wall Street.

"We watch markets very carefully," Powell said at a mid-November event in Dallas. "But it's one of many, many factors going into a very big economy."

But investors were not just reacting to the Fed and the prospect of higher rates. Weakening business and consumer confidence, slowing global growth, and potential disruptions from President Donald Trump's trade war with China also factored in.

Over the next few weeks, the Fed tried to build those concerns into its political stance, but it became clear that the situation was more fragile than they had divined.

At the beginning of December, the yield curve "inverted," with short term rates rising above long-term ones in what can be seen as a loss of faith in economic growth.

For months, Fed officials have been debating whether to discount such developments as the clash and clang of daily trading or to treat them as a significant warning. Some, including Bullard, warned against ignoring what markets seemed to say, and both he and Kashkari said the Fed should stop raising rates or risk trouble.

When the Fed met in December, politicians thought they could square the circle.

Officials proceeded with another quarter-point rate increase, as expected, and projected updated projections showing two more rate hikes for 2019 – one less than in September, but still heading higher.

LOST NUANCE

The Fed hoped, however, that between a small change in its policy statement and Powell's follow-up news conference, things would stay calm, and a strategy Fed officials spelled out after the fact in interviews and in minutes of the December meeting.

By replacing the phrase that the Fed "expected" further rate hikes with one saying it "judged" them likely, the central bank tried to show it was now less committed to tighter policy.

But that nuance was lost on markets, and Powell's assurance at the news conference of a new "patient" Fed got lost as well when he described Fed's monthly $ 50 billion in assets as "automatic pilot. "

To investors, that undermined the intended message, since the regular decline in Fed's asset holdings effectively worked to tighten financial conditions.

The S & P 500 fell another 7.5 percent in the days that followed.

Investors felt the Fed was "not fully appreciating" how market turbulence and "softening global data" put the US itself at risk, the Fed's January Minutes concluded in reviewing how the December statement was perceived.

"It was a delicate time," New York Fed President John Williams told Reuters on Tuesday. The tweak in the December statement was a pretty subtle message. That's one of the challenges of trying to communicate a very complicated and complex situation in just one page. "

Over the next few weeks, the Fed eschewed subtlety for a more public acknowledgment that its view of economic reality had changed.

For a Jan. 4 question-and-answer session at the American Economic Association Powell came armed with written notes and a core message that the Fed was "always prepared to shift the stance of politics and shift it significantly" if conditions weakened.

After the January meeting that message became official. References to the new "patient" approach and "silent inflation," cited in the minutes of the December meeting, became part of the Fed's policy statement. A long lasting mention of the need for higher rates was deleted.

The changes have not been dissenting, with even those who have worried about inflation and financial risk falling silent.

It was a significant moment of unanimity at a central bank that has spent the last decade wondering when, rather than whether inflation or financial risks would re-emerge. During that time, a group of officials – including Powell early in his central banking career – has consistently warned that the combination of falling unemployment, cheap money and trillions of dollars injected by the Fed's crisis era would inevitably cause problems.

FILE PHOTO: Federal Reserve Chairman Jerome Powell holds a press conference following a two day Federal Open Market Policy meeting in Washington, US, January 30, 2019. REUTERS / Leah Millis – / File Photo

As the Fed's January meeting minutes showed that not all officials have sworn off further rate increases and some have noted that a possible turn for the better – a resolution of trade tensions for example – could lead them to raise rates again.

But to veteran Fed watchers, the bar is now higher. The January statement, JP Morgan analyst Michael Feroli wrote recently, showed the Fed "subtly but profoundly evolving" to a new view of the world where a variety of forces have changed the way inflation and interest rates work, and have now changed how central bank responds.

GRAPHIC – The Fed's New Normal: tmsnrt.rs/2VccqWm

Reporting by Howard Schneider; Additional reporting by Ann Saphir and Jason Lange; Editing by Dan Burns and Tomasz Janowski

Our Standards: The Thomson Reuters Trust Principles

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