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The Fed changes its tune

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      By Eric Stein, CFA, Co-Director of Global Income, Eaton Vance Management

      Boston - Last month when the Federal Reserve hiked rates as expected, I blogged that Fed Chair Jerome Powell in the post-announcement press conference seemed tone deaf to what the financial markets were saying.

      Even before December's violent sell-off, a flattening yield curve and softer inflation readings had been signaling worries about trade tensions and the health of the economy. Yet as I wrote last month, Powell at his December press conference seemed to be ignoring these concerning market signals. In particular, many market participants seemed surprised by Powell's assertion that the pace of Fed balance sheet normalization was on "autopilot."

      The takeaway was that the Fed wouldn't even consider slowing the pace of shrinking its balance sheet. The market also didn't seem to like Powell's comments that December volatility in financial markets wouldn't impact the real economy.

      Walking it back

      Since last Friday, Powell and other Fed officials seem to be taking a more dovish stance. It started last week at the annual American Economic Association (AEA) meeting when Powell, on stage with former Fed chiefs Janet Yellen and Ben Bernanke, said the Fed was carefully listening to the markets.

      Powell added the central bank wouldn't hesitate to rethink its balance sheet normalization approach if it was causing problems in the markets. Following these comments, equity and credit markets rallied and the U.S. dollar started to weaken.

      This week, we are getting more of the same with more Fed officials helping walk back Powell's comments after the December hike. For example, yesterday I attended a talk where Boston Federal Reserve Bank President Eric Rosengren acknowledged the uncertain outlook and said the Fed can afford to be patient on rate hikes, based on economic and market signals. Rosengren was very balanced in his remarks, noting that while he was more optimistic on the U.S. economy, it makes sense for the Fed to be in a wait-and-see mode.

      Finally, the Fed minutes released this week from the December meeting also had a somewhat dovish tone, especially compared to the Powell's hawkish comments at the December press conference.

      Putting it all together, I think the recent Fed speeches and the December meeting minutes are very much part of a concerted effort by the Fed to walk back the December press conference -- which I think was a combination of some overall poor communication by Powell, but also a Fed that in my view wasn't taking seriously enough the message financial markets were sending it.

      I think the Fed has certainly changed its tune, and while growth is strong, inflation is basically at target to a touch below, so there is no pressure to be so aggressive with future rate hikes.1

      Bottom line: If financial conditions continue to ease from here (as they have to start the year) and growth stays strong, I think the Fed will look to hike rates in 2019, but for now a wait-and-see approach is prudent, and recent Fed communication shows the Fed is taking this approach. From a markets perspective, my view is the Fed's newfound dovishness should be very good for emerging market assets, as well as for credit and equities.