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Close look: Fed signalling - What's the big story?

3 years ago

There is an old market saying: Don’t fight the Fed. The US Federal Reserve, popularly known as the Fed, is the world’s biggest central bank. As such it has huge fire power and it would take a brave or foolish trader to bet against it. Although never explicitly stating their plans, the Fed does offer regular signals on future monetary policy moves. And while market stability might not be part of their mandate, the Fed certainly has the ability to move markets with a few words.

It’s not such a guessing game as it once was. Forward guidance, introduced in the early 2000s, makes it easier to interpret the Fed’s thinking. But financial markets should always be aware that the guidance only holds good for the short term. As the governors who make up the Fed’s monetary policy-setting body come and go, emphasis and policy can change. This could explain why the Fed’s press conferences are so closely followed and any change in nuance much discussed.

One thing is perfectly clear. As financial markets collapsed under lockdowns in March, Chairman Jerome Powell stated that ‘there’s no limit’ to the monetary stimulus the Fed would provide. Given infinite liquidity, markets rallied hard. But if the central bank always steps in when asset prices tumble, where is the downside risk for investors? Financial markets might have become dependent on the Fed’s generosity. It’s been said that the bull market party could end pretty abruptly, if the Fed ever removes the ‘punch bowl’ of liquidity.

Guidance on the Fed’s policy framework recently changed, to include flexible average inflation targeting or FAIT. Inflation has been running below the target level of 2% for some years. With FAIT the Fed can now allow inflation to ‘run hot’ for some months, before responding with a hike in interest rates to bring it back down. It seems prudent, given that a jump in prices could well be on the horizon following huge central bank and government stimulus. Now the Fed can avoid being forced into raising rates if inflation ticks up, particularly as the recovery might still remain fragile.

It’s fair to say that the financial markets rely on the Fed, not only for monetary stimulus, but also for policy guidance. So much so, that any reluctance to send signals can be unnerving. The lack of a green light from the Fed can trouble the markets just as much as the obvious red light of interest rate hikes. In the face of high valuations and geopolitical uncertainties, Fed signalling continues to walk a tightrope between reassurance and false hope.

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