To The Moon

What is a Fed Pivot and Why Does It Matter?

By ADAM HAYES

Updated October 17, 2022

Fact checked by SUZANNE KVILHAUG

What Is a Fed Pivot?

A Fed pivot occurs when the Federal Reserve, which is the U.S. central bank, reverses its policy outlook and changes course from expansionary (loose) to contractionary (tight) monetary policy—or, conversely, from contractionary to expansionary.

A Fed pivot typically happens when economic conditions have fundamentally changed in such a way that the Fed can no longer continue its prior policy stance.

KEY TAKEAWAYS

A Fed pivot is when the Federal Reserve reverses its existing monetary policy stance.

This can be a change from contractionary to expansionary policy or vice versa.

As the U.S. central bank, the Fed is responsible for setting and implementing the country’s monetary policy.

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A Fed pivot occurs when the underlying economy has changed to such a degree that the Fed can no longer maintain its existing monetary policy.

If the Fed pivots unexpectedly, markets can react violently.

How a Fed Pivot Works

The Federal Reserve is the U.S. central bank, meaning that it is in charge of the nation’s monetary policy. The Fed has a dual mandate: to maintain both price stability and full employment. If inflation rises and unemployment falls, the economy may overheat, so the Fed will enact a tight, or contractionary, monetary policy—such as raising interest rates—to try to slow economic growth and let the economy cool. Likewise, if inflation is low and unemployment is high, the Fed may enact a loose, or expansionary, monetary policy to stave off recession by lowering interest rates and pumping more money into the economy.

Once a monetary policy has been set and implemented, it can take several weeks or months before the effects of the policy are felt in the economy. Once they are, the Fed typically maintains its existing policy to some degree to maintain stability and avoid spooking the markets.

However, if the fundamentals of the economy shift dramatically, the Fed is forced to reevaluate its position and may decide to pivot—that is, to reverse its monetary policy stance. Thus, if interest rates are low and the Fed is employing quantitative easing (QE), it would pivot by increasing interest rates and tapering QE. A pivot in the other direction would entail the reverse. In either case, doing so can be disruptive in the short term as market expectations and business forecasts are revised in light of the new policy.

Examples: Why and When the Fed Pivots

The Fed currently has set a target rate of inflation at 2% annually, and it seeks to maintain full employment.

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As a result, it will shape its monetary policy in reaction to the state of the economy and its forecasts about the future. This includes setting interest rates, in the form of targeting the federal funds rate, or the short-term interest rate at which commercial banks borrow and lend to one another. When the economy is expanding, the Fed can raise rates and keep them relatively high, and when the economy is slowing down or contracting, the Fed can instead lower rates and keep them low.

Let’s look at some recent examples using the chart below, which depicts the fed funds rate since January 2000. In late 2000 into 2001, the dot-com bubble burst, sending the U.S. economy into a mild recession. Toward the end of 2000 and through 2004, the Fed pivoted to a loose monetary policy, cutting interest rates to 1.0% from 6.5% over a period of more than 36 months and maintaining its policy stance until the summer of 2004. That’s when it again pivoted and began increasing interest rates, to 5.25% from 1%, again over a period of around three years as the economy grew.

Due to the 2007–2008 financial crisis, the U.S. economy entered a deep contraction, known as the Great Recession. During this time, unemployment was high, economic growth lagged, and inflation fell well below its 2% target, where it remained for several years.

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As a result, the Fed pivoted from its prior policy and again slashed interest rates, this time down to a record low 0%–0.25% target. This expansionary policy stance persisted for nearly a decade before the Fed slowly pivoted and raised rates again, reaching around 2.5% in 2019.

In the spring of 2020, the global COVID-19 pandemic rocked the economy, as lockdowns and business closures put a halt to the slow and steady economic expansion that preceded it. The Fed promptly pivoted and again quickly cut rates to close to 0%, where they again remained until the spring of 2022. In early 2022, inflation began creeping up and then exploded higher that summer to levels not seen since the early 1980s. The causes of this sudden rise in prices include Russia’s invasion of Ukraine, which sent food and fuel prices soaring, coupled with employment and global logistics snarls that have remained since COVID lockdowns. This caused the Fed to once again pivot and aggressively raise interest rates in an effort to tamp down rising prices.

Do Fed pivots always work?

The Federal Reserve (Fed) pivots in response to a changing economy, to maintain price stability in light of new fundamentals. Critics argue, however, that the Fed’s pivots can be too late, reacting after the fact rather than preempting a change in economic currents. Others have argued that Fed pivots do not always last long enough, such as during the 1970s, when the Fed eased its aggressive tightening too early, paving the way for stagflation.

Are Fed pivots predictable?

In recent decades, the Fed has greatly increased its transparency and been better at signaling its intentions to the investing public. Still, a Fed pivot and when exactly it will occur remains a matter of expectations and educated guesswork. Fed funds futures and options markets can be used to view the market’s implied opinion for future rate hikes or cuts, but this can only give a set of probabilities, rather than definitive answers. If the Fed is slow to react, or makes a policy move that does not align with market expectations, stock prices can take a hit.

How does the Fed set interest rates?

In the United States, interest rates are determined by the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board (FRB) and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates, which is done by a majority vote.

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The Bottom Line

A Fed pivot involves the U.S. central bank changing course and reversing its prior monetary policy stance. If the economy appears to be entering a recession, the Fed may pivot from a high interest rate environment to an accommodative monetary policy, featuring lower interest rates, increased open market operations (OMO), and quantitative easing (QE).

Alternatively, if the economy seems to be overheating, with low unemployment and high inflation, the Fed may instead pivot from low interest rates to a contractionary policy, involving higher interest and tapering of QE and OMO. Fed pivots are done in reaction to the state of the economy, but if they come too late or are not aggressive enough, then they may not be able to keep up with changing fundamentals.

source: https://www.investopedia.com/fed-pivot-definition-6748840