Fed's Dudley: "I Don’t Think We Are Removing The Punch Bowl Yet"

In case there was still any doubt as to what the "data-dependent" Federal Reserve reacts to, it was once again removed today when speaking in remarks at the University of South Florida in Sarasota, Florida, NY Fed president Bill Dudley said that "it is important not to overreact to every short-term wiggle in financial markets." Which confirms that the Fed has traditionally overreacted to every short-term wiggle in financial markets, and which contradicts what both Kocherlakota and what Rosengren said previously, namely that the market is "not a driving force" for the Fed's outlook.

Of course, we appreciate Dudley's wry humor in stating that the Fed should not unleash the Bullard every time there is an even 5% S&P correction with threats of QE4, although with the elections now far in the past, we can see why the Federal Reserve would not mind a "modest correction" something both Evans and Rosengren warned yesterday could happen as the market is now clearly "frothy."

That said, don't assume the Fed will allow a full blown crash: because as Dudley also said in his speech,while the Fed is "not removing the punch bowl yet" - his words - it is "just adding a bit more fruit juice." To wit:

"prior to the March FOMC meeting, financial conditions were generally easing rather than becoming tighter, even as the FOMC raised its policy rate in December and market participants increasingly expected further policy tightening in the coming year.  Between the December and March FOMC meetings, U.S. equity prices rose by about 4 percent, and credit spreads, such as those for high-yield bonds, narrowed.  Long-term yields and the trade-weighted dollar were little changed over this period.

 

William McChesney Martin, the ninth chair of the FOMC, once famously opined that the Federal Reserve is “in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”  I don’t think we are removing the punch bowl, yet.  We’re just adding a bit more fruit juice. 

Maybe not removing the punch bowl yet, but by stating clearly that it is being diluted, Dudley confirmed what Goldman said two weeks ago, when the bank warned that the market has misread the Fed's recent hike, which was not dovish, but was meant to be a hawkish, if modest, tightening of financial conditions.

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In addition to the above comments, Dudley also said that tapering of the Fed's balance-sheet reinvestments may be “a better course” than an earlier, abrupt end.

Among his other statements:

  • Any announcement of changes to reinvestment policy is likely to tighten financial conditions, push up long-term rates.
  • Fed will need to take into account the impact of any changes to reinvestment policy in its rate decisions
  • Reducing balance sheet and raising short-term rates are “two different, yet related, ways of removing” accommodation
  • Fed funds target range of 0.75%-1% is still unusually low; seems appropriate to scale back accommodation gradually
  • Risks for growth, inflation may be shifting to upside; seems likely that fiscal policy will become more stimulative
  • Economic outlook abroad appears to have brightened; risks from overseas seem significantly lower than a year ago; Now more confident that inflation will stabilize ~2% in medium term
  • “Financial conditions need to be carefully considered” in conduct of monetary policy’’
  • “What we care about is not financial conditions themselves, but rather their influence on economic activity”
  • No simple answer to when FOMC should take changes in financial conditions into consideration in its decisions
  • While financial conditions influence economic outlook, “so do many other factors”