The architects of the market-unfriendly term called “Fed tightening policy” put its stability under great doubt, as was shown by the December Fed minutes. There was an impression that Powell reported only his own policy views at the meeting in December (which he later ditched) because the document is simply filled with statements about the need to significantly slow down the process of rate hikes.

In the light of the protocol, December dot plot looked odd, where the median rate forecast at the end of 2019 was 2.875%, while only two FOMC participants agreed with the most likely outcome assumed by market (225-250 pp):

In less than a month, there was a complete transformation of the Fed from an adamant hawk into an agreeable dove:

  • FED OFFICIALS SAW EXTENT, TIMING OF FUTURE HIKES AS LESS CLEAR;
  • MANY OFFICIALS FELT the FED COULD BE PATIENT ON FURTHER RATE HIKES;
  • FED: A FEW OFFICIALS FAVORED NO RATE INCREASE AT DEC. MEETING;
  • FED: SOME OFFICIALS NOTED DOWNSIDE RISKS MAY HAVE INCREASED.

It should be noted that the protocol was largely devoted to sentiment in financial markets, which contrasts sharply with the previous position, stubbornly ignoring the disappointing conclusions of markets about the effects of policies that focused solely on responding to changes in macroeconomic parameters:

“Asset prices were volatile in recent weeks, reportedly reflecting a pullback from risk-taking by investors. In part, the deterioration in risk sentiment appeared to stem from the uncertainty about the state of trade negotiations between China and the United States. In addition, investors pointed to concerns about the global growth outlook, the unsettled state of Brexit negotiations, and uncertainties about the political situation in Europe”

It is also curious that the protocol mentioned the possible excess of the effective federal funds rate over the interest rate on excess reserves (IOER) due to the current pace of balance reduction. It is noteworthy that this will happen for the first time since the crisis of 2008:

What does this mean? Speaking about open market operations, reducing the balance of assets the Fed withdraws liquidity in the economy, which makes borrowing between banks all the more expensive. In turn, it is becoming less and less profitable for banks to keep excess reserves on the Fed’s balance sheet, as the opportunity costs grow (it is profitable to lend in the interbank market):

Thus, the upward pressure on the interbank rate from the tapering off QE balances downward pressure from banks, which take excess reserves from the Fed and lend to other banks. Thus, IOER largely had to be a convenient tool for controlling the effective interest rate on federal funds:

The protocol also clarified the essence of the change in the wording “The committee expects that further gradual increases” to “The committee judges that some further gradual increases” in a December statement, which turned out to be based on the limitations of the policy forecast horizon. Or, in other words, the dot plot is relevant, but the forecast for the end of the year is too far to rely on it. The word “judges”, in contrast to “expect”, in this context, means more dependence on incoming data, be it signals from the economic front or financial markets.

In general, the protocol marked a significant rollback in plans to raise rates, confirming Powell’s recent comments. In my opinion, the dollar is losing almost completely its growth potential.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.

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