By Nick Timiraos 

Flexibility is emerging as the hallmark of Jerome Powell's response to the first economic curveball he has faced during his tenure as Federal Reserve chairman.

On two fronts -- interest rates and the Fed's asset portfolio -- Mr. Powell has abruptly changed course in just three months. In doing so, Mr. Powell is showing he cares more about crafting what he thinks is the right policy than winning an argument with either markets or economists.

The twin pivots were "quick by Fed standards," said Steven Blitz, chief U.S. economist at TS Lombard.

The Fed and the markets fell out of sync after the central bank raised its short-term benchmark in December and signaled two more increases this year. Mr. Powell also signaled then that officials saw little reason to adjust the steady runoff of their $4 trillion asset portfolio, which had been shrinking by about $40 billion every month.

Many investors, worried about rising risks to U.S. growth from abroad and from political uncertainty, had hoped the Fed would suggest it might not raise rates at all in 2019. Others said the portfolio runoff was tightening policy too much.

By Wednesday, the Fed had given the market what it wanted in December. On rates, the Fed signaled it is indefinitely on hold due to heightened risks to the global economy and because strong U.S. growth and falling unemployment last year didn't deliver an expected upturn in inflation.

On the portfolio, most Fed officials still don't believe the runoff of their mortgage and Treasury holdings played a major role in the market's swoon late last year.

The drawdown of Treasurys and offsetting bank deposits, or reserves, from the Fed's balance sheet has been accompanied by an equivalent increase in Treasury securities held by banks. This undercuts the idea pushed by some investors that the balance-sheet runoff was draining liquidity from the financial system.

But rather than trying to prove its argument to markets, the Fed moved up plans to announce how and when it would stop shrinking its holdings. The central bank said Wednesday it would slow the pace of Treasury-bond redemptions in May and end the runoff by October. It hasn't yet said when it will allow the balance sheet to expand, which will stop the gradual decline of bank reserves.

"We're in this situation where the chairman of the Federal Reserve is the most flexible actor on the stage today, and that's not usually the case at the Fed," said Jim Vogel, a rate strategist at FTN Financial.

The path hasn't always been a smooth one for Mr. Powell, who like every new Fed leader faced early communications missteps. The recent about-face led some analysts to warn that the Fed is introducing more uncertainty about how it will react to future changes in the economy or that it erred with December's rate increase.

Mr. Powell became Fed chairman 13 months ago facing a different economic environment. Back then, the Fed's models suggested inflation was likely to rise amid declining unemployment, tax cuts and a federal spending boost.

By September, more Fed officials were talking about the need to raise rates eventually to a level high enough to curb growth.

Markets began falling in October and turned more volatile in November and December. China and Europe showed more indications of a slowdown, following weakness that buffeted some emerging-market economies earlier in the year. Meanwhile, trade tensions between Beijing and Washington showed few signs of easing.

Volatility accelerated after the Fed's December rate increase. Corporate borrowing costs widened, while government-bond yields tumbled.

By January, various recession indicators began flashing caution. One such measure highlighted by Fed researchers last summer, which compares the difference between the yields on three-month Treasury bills and the yield implied by futures markets for the same bills some six quarters later, turned negative. In January, it showed a 50% probability of recession.

Mr. Powell signaled the Fed was pausing from raising rates when he spoke at an economics conference in Atlanta on Jan. 4. Officials hardened that commitment after their statement on Jan. 30 dropped language about future rate rises, and again on Wednesday, when most of them projected no increases this year.

"Even if it's wrong, the speed with which they're moving is impressive," said Mr. Vogel.

Mr. Powell's stance reflects a risk-management approach that tries to balance the risks of policy being too loose, fueling unwanted inflation or asset bubbles, with the risks that the central bank could tighten policy too much and prematurely end the expansion.

Mr. Powell appears eager now to accept the risk that the economy stabilizes and the Fed is forced to raise rates again. "They're totally willing to accept that trade-off, because it means they have avoided a minor recession," said Mr. Blitz.

Mr. Powell has previously noted how the Fed has much less margin for error when rates are historically low, as now, with its benchmark rate in a range between 2.25% and 2.5%. If growth falters, policy makers run out of room to cut rates once they are lowered to zero, which central bankers call the "zero lower bound."

"You're not away from the zero lower bound the week you lift off," Mr. Powell said in November 2016, when the Fed had raised its benchmark rate just once from near zero. So long as the benchmark rate is below 3%, "you're thinking, 'I need to be careful here,'" he said.

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

March 22, 2019 05:44 ET (09:44 GMT)

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