Financial crises can be predicted — and avoided
Minutes show a much more upbeat Fed on the economy than markets are
At the Federal Reserve's decision-making Federal Open Market Committee (FOMC) meeting on Jan. 29, it made several announcements that seemed to demonstrate substantial changes in policy.
The nation's central bank officially stated that it would be "patient" about raising the federal funds rate, the main interest rate it influences, changed its previous determination to continuously shrink its holdings of bonds and stated clearly for the first time that it would not attempt to go back to its older ways of managing banks' reserves.
The January announcements had a degree of drama to them. In December, President Trump had sharply rebuked the Fed for raising rates. Financial markets were in a funk, with stock prices falling and volatility rising.
Financial market analysts criticized the Fed for blindly sticking to a predetermined plan rather than reading the new realities of a weakening global economy, rising uncertainty about trade negotiations with China and a disruptive government shutdown.
The minutes released on Wednesday show the Fed noting these concerns expressed by investors and market participants (no mention is made of President Trump). However, the Fed's own analysis remained then, and remains today, far calmer and in fact far more optimistic than the markets'.
Both Fed staff and the leaders on the FOMC see the economy as relatively healthy. The Fed did downgrade its assessment of economic growth from "strong" to "solid" - a downgrade so subtle that NPR's Kai Ryssdal actually called a linguistic expert onto his Marketplace program to interpret it.
Central bankers are famous for burying important information in mind-numbing jargon and infinitely careful language. But the reality here is that the Fed's change in assessment really was not that big at all.
Reading the details of the Fed's review of economic and financial trends, I could not find anything terribly exciting or worrisome. The Fed does predict slower growth in 2019 and 2020 and even modest increases in unemployment, but there simply is nothing dire in their discussion.
The disconnect between the Fed and the financial markets can also be seen in the discussion of the Fed's shrinking of its bond portfolio. The minutes make clear that the Fed does not see this as having much impact on long-term interest rates.
These are the interest rates companies pay to borrow for major investments like a new factory, or the interest rates homebuyers deal with when they look for a mortgage. The minutes blandly deny that the Fed's moves led to increased long-term interest rates.
They also opine that the sharp decrease in investor willingness to take risk that became apparent in the markets in November and December had to do with other factors, not with the Fed.
So why, then, is the Fed changing course on shrinking the bond portfolio? The minutes suggest that the shift was already brewing within the Fed. When the Fed bought all those bonds, they put enormous amounts of money into the hands of banks.
But the banks did not really have much to do with all of that cash, so banks held a staggering $2.8 trillion of reserves. As the bond portfolio has shrunk, bank reserves have fallen to only $1.2 trillion. That can happen directly, when banks use the reserves to buy bonds, but it can happen through other channels as well.
It seems that the Fed staff had already been thinking that this much lower level of reserves was approaching the ideal level. The FOMC adopted the staff position in an additional statement put out in January, in which they announced that the Fed embraced the new monetary order of high bank reserves and large Fed bond holdings.
They do not believe that we can go back to the pre-2008 situation of much lower reserves and a Fed holding rather few bonds because they believe that the old patterns of bank behavior no longer apply.
Perhaps the need to take a pause from raising interest rates and the decision to recognize the new monetary reality just happened to coincide. The Fed is not saying to the markets, "You were right, we were wrong."
In fact, the minutes show that some Fed members still think that it will be necessary to raise the federal funds rate again later this year. Others worry that inflation could be chronically below the Fed's 2-percent goal.
In short, while the FOMC was unanimous about the need to sit back and do nothing with interest rates in January, there are different views about what comes next. For the general public, the Fed's own words probably apply: We will have to be patient to see where the Fed is heading.
Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.