Must-Read: Gavyn Davies: What Caused the Fed’s Dovish Turn?

Gavyn Davies: What Caused the Fed’s Dovish Turn?:

The change in the Fed’s guidance about “normalisation”… came… [as] the dollar peaked (and equities collapsed) in February/March…

…a change in their expected mix between the exchange rate and domestic interest rates in delivering the tightening in financial conditions that they desired at the time. A higher dollar essentially forced them to accept lower interest rates in order to deliver roughly the same path…. Furthermore, this was not expected to be just a temporary shift…. The best analysis of this issue from inside the Fed has come from Lael Brainard… the importance of global deflation risks, especially in China. These risks will lead to a very long period of aggressively easy monetary policy outside the US, which in turn will make the dollar far more sensitive to US rate hikes than has been the case in some earlier periods. The Fed should not, she argues, ignore this when setting US rates: the equilibrium interest rate in America has been reduced by events overseas. This analysis lies outside the Fed’s normal comfort zone, and contradicts the standard analysis produced by Stanley Fischer among others last year. It was overlooked entirely by Ben Bernanke last week. But it does seem to have determined the behaviour of the FOMC for much of this year.