Federal Reserve’s flip-flops risk undermining US exceptionalism

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

“We don’t guess, we don’t speculate and we don’t assume.” That is what Jay Powell asserted last month when asked whether Federal Reserve officials incorporated into their policy thinking the plans of incoming president Donald Trump. Investors and economists are trying to figure out whether this is still true amid the unsettling market volatility that followed last week’s Fed policy announcements.

The inherent uncertainty over the answer to that question is just one way the Fed’s highly reactive policy approach amplifies financial volatility. The reaction of longer-term bond yields also helps explain why Americans find it confusing that just when the media tells them that the central bank has cut interest rates, the cost of the mortgages they are looking at increases.

At its Wednesday policy meeting, the Fed accompanied a 0.25 percentage point cut in rates with more hawkish forward guidance. That signalled fewer rate cuts in 2025 than had been indicated before and a higher terminal rate, the long-term target of the central bank. The chair’s press conference that followed was the most confused and confusing of a series of less-than-stabilising affairs in recent years. It was full of contradictions.

At times, Powell said the recent string of “sideways” inflation readings meant the Fed’s approach could be “more cautious” on future monetary easing. At other times, he stated that the central bank’s policy stance remained “meaningfully restrictive” even after Wednesday’s rate reduction.

It is not surprising that, in such a context, both stocks and government bonds saw unusually large intraday moves for a “Fed day”. The S&P 500 shed 3 per cent, and the yield on the 10-year government bond rose more than 0.1 percentage point. This yield move was the largest on a Fed day since 2013’s so-called taper tantrum, when the central bank signalled it might begin to scale back bond purchases and the S&P 500 declined by the largest margin since 2001. Meanwhile, the Vix index, commonly viewed as Wall Street’s “fear gauge”, spiked from about 15 to an intraday high of 28.

The market narratives on the now “stop-go” Fed were equally volatile. Some, pointing to Powell’s mention of “a new phase”, argued that the Fed was positioning for what officials deemed the inflationary effects of the incoming administration’s inclination for higher tariffs, big tax cuts and significant labour force retrenchment due to the large-scale repatriation of illegal immigrants. Others attributed the hawkish shift to inflation dynamics that once again surprised and confounded the world’s most powerful central bank.

While there is no certain answer to this key question, there is also a more persistent force in play here, as I have lamented before, and it continues to be under-appreciated by many. Wednesday’s announcement is part of a larger pattern of flip-flops.

As an illustration, in just the past five months, the Fed’s actions have ranged from no cut (end of July), to a jumbo 0.5 percentage point “re-calibration” cut (mid-September), to a 0.25-point cut amid a seemingly “nothing-to-see-here” pace (early November), to the upending of earlier forward policy guidance and economic interpretations (mid-December).

Also note the significant degree of internal divergence. The updated “dot plot” of economic projections of policymakers shows a striking range of estimates for where the Fed should take rates by the end of this cycle, from under 2.5 per cent to almost 4 per cent.

A persistent lack of strategic policy anchoring helps explain the current policy confusion. The Fed became excessively data-dependent after its big inflation mistake in 2021-22, when it wrongly assumed price spikes were transitory. As a result, policy goes in whatever direction the latest data is blowing, leading to about-turns.

Market participants were right to feel uncomfortable listening to Wednesday’s press conference. In addition to speculating on the significance of the Fed’s latest flip-flop, they should also embrace a more basic reality: the continuation of the central bank’s excessive data dependency increases uncertainties in the US economy.

This matters beyond the US as its exceptional economy is the only current meaningful locomotive of global growth. In turn, that heightens the risk from global and domestic political forces currently rippling around the world, as well as aggravating the domestic challenges faced by countries ranging from Brazil to Japan.