Fed is weighing growth against market fragility

Resisting unusual pressure from both politicians and notable market participants, Federal Reserve Chairman Jerome Powell and his colleagues on the Open Market Committee raised interest rates by 25 basis points and slowed the path for future hikes by less than markets hoped.
In doing so, the central bank reaffirmed that its focus remains firmly domestic and economic. But markets’ reaction suggested the move was seen as heightening concerns about a policy mistake, rather than responsible policy making. This, and what’s likely to play out over the next few weeks, illustrates a bigger phenomenon: the threat that the Fed and other central banks are increasingly in a no-win situation, due to factors mostly outside their control.
The Fed’s updated economic assessment is somewhat less rosy than those it made before, and includes a slight downward revision in next year’s gross domestic product. Still, policy makers seem less concerned than markets about the spillbacks to domestic consumption and investment from weakness in the rest of the world and technically vulnerable asset prices. For that reason, the central banks’ median expectation for next year’s rate hikes is still well above the markets’, and policy makers remain comfortable with the notion that they could slightly overshoot the neutral rate estimate in 2020. Although these predictions are described as highly data-dependent, as is customary for the central bank, they unsettled markets across the board.
For several years after the 2008 global financial crisis, the US economy was stuck in a new normal of low growth, soaring asset markets, and dampened financial volatility. This was due in large part to the decision of systemically important central banks to pursue their economic objectives through the asset channel: ultra-low interest rates and securities purchases as a means of encouraging risk-taking, triggering households’ wealth effect and encouraging higher business investment. China-driven global growth also contributed to asset-price inflation and volatility
repression, as emerging-market stocks outpaced their US counterparts.
Some expressed concerns about the risks and unintended consequences of central banks continuously “goosing” markets. But these cautions gained little traction, for understandable reasons. After all, central banks were motivated by noble economic objectives whose importance was accentuated by how close the world had come to a multiyear global depression, a threat that imparted a bias to policy makers’ risk-management paradigm.
A still-solid US economy isn’t sufficient to dampen financial volatility and resist price declines in the context of structural market fragilities. This is due to five main factors: The outlook for Europe, Japan and China is considerably more uncertain than the prospects for the US markets also have to adjust to losing the predictable and ample liquidity support they
received from the European Central Bank.
It has become customary for new central bank chiefs to be tested early in their tenure. In Powell’s case, the challenge has taken the form of a controversial policy decision due to the competing pull of domestic economic conditions and the combination of technical market fragility and a slowing international economy. This tug-of-war is unlikely to end any time soon.

—Bloomberg