Is the Federal Reserve beholden to short-term volatility in the financial markets?
A handful of Fed-watchers argue that the answer is yes, based on language from the Federal Open Market Committee’s meeting minutes released Wednesday. They point to two words: “premised importantly.”
“Revealingly, participants noted that low borrowing costs and high equity prices were ‘premised importantly’ on expected Fed rate cuts,” Capital Economics’ Michael Pearce wrote on Wednesday. “Translation: The Fed is petrified of upsetting the markets and will therefore continue cutting rates.” (emphasis added)
Here’s the full quote from the July FOMC minutes for context: “Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks.“
So, by not providing the easing expected by the market, the Fed recognized that it could be directly contributing to the forces hindering the economy.
Nomura’s Lewis Alexander agreed with this assessment: “This is consistent with the view that the market’s expectations for the Fed action played a role in the decision to cut rates in July.”
The Fed said this before the July rate cut
This is actually not the first time the Fed connected financial conditions with rate cut expectations by employing the words “premised importantly.” This was from the June FOMC minutes: “While overall financial conditions remained supportive of growth, those conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy in the near term to help offset the drag on economic growth stemming from uncertainties about the global outlook and other downside risks.”
At the time, Barclays economist Jonathan Miller argued that “this acknowledgment greatly strengthens the case for rate cuts in July; members will be worried about a back-up in financial conditions.”
Nomura’s Alexander also flagged the language, saying that “policymakers are mindful of the potential inadvertent negative impact on financial markets stemming from inaction.”
The Fed went on to cut rates for the first time since 2008, an event that was widely priced into the markets.
‘Levering the outlook to self-determined financial conditions’
On Thursday, BNP Paribas economists wrote that they were “struck” by this language when they saw it in June, further noting that the Fed “appeared to acknowledge its own role in maintaining the accommodation of financial conditions that it exogenously factors into the economy.” (emphasis added)
By acknowledging its own role in this way, the Fed then is effectively referring to itself when it speaks of financial conditions. With this in mind, BNP found another statement in the July FOMC minutes to be telling.
“[W]hile the Committee has long factored financial conditions as an important input into the outlook, the July Minutes took it a step further, with the Committee stating that its outlook for continued sustained expansion of activity ‘was predicated on financial conditions that were more accommodative than earlier this year,’” the economists said.
They unpacked this a bit: “The Committee appears to be acknowledging that: 1) accommodative financial conditions are underpinning its current outlook for continued expansion; and 2) market expectations of further cuts are in turn underpinning such accommodative financial conditions.”
And so, the Fed is effectively saying it will at least be partly to blame for economic volatility, assuming it delivers monetary policy not in line with what the market is pricing.
“Taken together, this suggests that the Committee will be remiss to push back against market expectations, as doing so would, in its view, adversely affect its own economic outlook,” BNP said (emphasis added).
If this interpretation of the FOMC minutes is off, the Fed may want to clarify.
Sam Ro is managing editor at Yahoo Finance. Follow him on Twitter: @SamRo