Economic and Market Commentary

Decoding the Fed’s Dovish Turn

The Fed’s dovish pivot in March indicated that restrictive monetary policy is no longer warranted, but what does that mean for the markets? PIMCO experts Tiffany Wilding and Joachim Fels discuss this policy shift and what investors should know.

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Tiffany Wilding, U.S. Economist: We think the Fed may have finished its tightening cycle, and overall, more broadly, for the last year, we’ve been characterizing the balance of risks that the Fed is trying to manage as really twofold.

The first is the risk that the Fed overtightens by raising interest rates maybe a little bit too quickly relative to what the economy can handle, and then the second risk is obviously the Fed doesn’t tighten enough and you see more inflation risk rising.

Shot of Federal Reserve meeting.

At the most recent meeting in March, the Federal Reserve members put forth a forecast which basically had interest rates flatlining at the current 2.4 percent.

Chart: A double line graph compares the federal funds rate versus the nominal neutral rate from 1984 to 2019. The end of the time period shows a near convergence with PIMCO's neutral range.

So effectively, what the Fed was telling markets is, “We no longer see the need for restrictive monetary policy, and rates are going to flatline from here.”

Shots from a PIMCO forum.

Joachim, Global Economic Advisor: The fed's dovish pivot has important implications for our cyclical outlook.

First of all, looking at the US, I think the flatlines at what we call the new neutral for interest rates reduces the risk of monetary overkill, and therefore somewhat reduces the risk of a recession over the next 12 to 18 months.

Second implication is for other central banks.

Shots of U.S. Federal Reserve Building, European Central Bank building and an aerial shot of Tokyo.

A more dovish fed means that other central banks will also have to ease a little bit more. And we've already seen the European Central Bank on the one hand, and the Bank of Japan on the other hand extending their extremely low interest rate policy for longer.

And what that means is it gives more support to the global economy. It helps to counter the global downturn that we see unfolding over our cyclical horizon.

Tiffany: So with rates at 2.4 percent and expected to flatline, a lot of clients have been asking us if they think that there’s enough room for the Fed to stimulate the economy in the event of a downturn, and we think that’s a, definitely a key question.

So we think that there are really two ways that the Fed can, can make, ensure that it has enough firepower to stimulate the economy.

The first is, is focusing and strengthening its unconventional policy tools, and these were really the tools that they used after the 2008 financial crisis and they include tools like their quantitative easing programs where they, they actually buy bonds to depress longer-term interest rates, they also include ways in which to depress interest rates, including forward guidance, and there’s various ways that the Fed could enact forward guidance.

Post-crisis, they used calendar-based forward guidance, but there’s been more discussion more recently of what we call “make-up” strategies, one of which would be using inflation, and if you have a certain period where inflation undershoots your two-percent target,

Chart: A double line graph compares the Personal Consumption Expenditures price deflator versus a 2% inflation rate path moving from lower to higher from 1992 to 2018.

then you allow a, a period of overshoot in order to make up that undershoot.Home

Joachim: How likely is this to happen? We think it's quite likely that the fed will eventually incorporate some of that into its monetary policy. We think their approach will be evolutionary, rather than revolutionary. How can they achieve this? Well, they simply have to run the economy hotter for longer. And to do this, they have to keep interest rates lower for long.

So the implication is if the fed moves to these makeup strategies, that probably means that on average in normal times interest rates will be lower than otherwise.

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