The Fed is not in the driving seat any more

Several stylized facts suggest that the Fed is not in the driving seat of U.S. monetary policy any more.

  • The Fed’s independence is at risk as President Trump’s tweets and recent institutional reforms making it more accountable to public bodies and civil society, as well as higher pressure from public opinion, have significantly increased the number of constraints weighing on its decisions. A text-mining approach, based on an analysis of sentiments on social media, confirms that 2017-2018 was a turning point with regard to the perception of its policy.
  • The Fed is now too “market-dependent”. A policy reaction function with time-varying parameters shows that the Fed has increasingly attached a larger weight to the stabilization of market volatility, to the detriment of its targets on growth and inflation.
  • The Fed is less and less credible in fulfilling its dual mandate. Our proprietary indicators mirror a higher risk of persistently undershooting its 2% inflation target over the medium-term, an altered capacity to maintain a situation of full employment - should the economic cycle deteriorate again - and higher risks of policy mistakes.
  • The Fed has become a poor guide for the market. We show that cross asset correlations have reached a pretty high level in 2019. This is equivalent to a loss of directionality for the market, i.e. it suggests that the Fed has become a poor guide for investors but also shows that there won’t be any place to hide in case of a severe episode of stress.
  • The Fed is about to lose its grip on currency policy. Despite an easing of U.S. monetary policy, the USD Trade Weighted index reached a record high during the summer of 2019. This primarily reflects a loss of influence on currency issues because of the actions of the U.S. Treasury and the People's Bank of China (PBOC).

History tells us that weaker central banks are associated with a higher risk of recession. Policy mistakes range from prematurely tightening monetary policy, nurturing bubbles, or lacking the authority in circumstances requiring rapid and bold moves of stabilization. Separately, the lack of direction perceived by the market is propitious to the existence of multiple equilibria and self-fulfilling prophecies. This combination of factors is prone to increase the probability of recession, as observed today.


Alexis Garatti
Euler Hermes