As expected, the FOMC unanimously made no change in the fed funds target rate during the November meeting—leaving the level at 2.00-2.25%. Their formal statement offered few surprises, noting strength in underlying economic growth and labor markets.
In keeping with the quarterly pace of rate movements, fed funds futures peg the chances of a hike in December at over 80%. Many economists also expect 2-4 hikes during 2019, but this gets murkier, with risks to that base case including an intensification of trade tensions, which could cause some erosion to GDP growth and also raise inflation, as well as a later-cycle flattening in manufacturing and other areas. The Fed is no doubt cognizant (per their mentioning it) of the negative signals that a flat or inverted yield curve would send, but don’t claim to be overly concerned about this coming to pass.
The Fed dashboard remains little changed from the last meeting:
Economic growth: Real GDP for the third quarter came in at 3.5%, which was about in line with expectations, being elevated due to continued fiscal boosts from tax reform. Q4 estimates are a bit less robust, ranging from 2.6% according to the New York Fed’s Nowcast, to 2.9% by lately-more-optimistic Atlanta Fed GDPNow. The common theme seems to be an eventual deceleration in growth, with estimates for 2019 also being set in the mid-2’s. It appears that we may have peaked in terms of overall output, and while recent numbers have not raised too many red flags of possible recession yet, the probability for one has risen for the 2019-2020 timeframe.
Inflation: Last month’s CPI and PCE deflator fell back a bit to the 2.0-2.5% range—around the Fed’s target—which explains the committee’s apparent satisfaction with the current pace of policy. Headline inflation is largely driven by oil prices, which have come back to earth as of late with concerns over demand but also higher supplies coming on line. Wage growth has picked up, to 3.1% in last month’s employment report, which had been widely expected as some point. The effect and timing of wage inflation on broader goods/services inflation has been debated, but all else equal, could serve to sustain higher inflation than lower, and would keep the Fed hiking for longer.
Employment: Labor metrics remain extremely robust, with little evidence pointing to deceleration. In fact, it’s almost hard to overstate how strong these metrics are, exemplified by jobless claims and the unemployment rate reaching multi-decade lows. This has created positive effects through the entire spectrum of the population, including groups depicted as ‘unskilled’ and the ‘long-term unemployed’. As noted earlier, a byproduct is that wage inflation has picked up, in no small part due to a shortage of highly-skilled workers in certain segments, but it remains to be seen whether this effect trickles down to the broader population as well, as it has in the past. Maximum employment is a mandate unique to the U.S. Fed (compared to other central banks around the world); continued labor strength would keep pressure on rates to rise.
October has a storied history of volatile market activity, and this year has been no exception. While a variety of cross-currents have contributed, including trade concerns, mid-term election results and sustainability of corporate earnings, uncertainty about the Fed’s ‘end game’ for rates has been one of the most important. In contrast to several historical episodes, though, when rates were hiked sharply due to the Fed perhaps being ‘behind the curve’, and done during times when central bank communication was non-existent or opaque to say the least, current policy has been much more choreographed and measured in order to avoid market surprises.
However, this maturation of the cycle doesn’t mean that conditions are poised to fall apart. Economic and corporate metrics continue to show growth, they’re just not as buoyant as they once were. Therefore, it’s always prudent to keep return expectations in check and be prepared for higher levels of volatility, as the straight-up market movement with below-average volatility is more the exception than the rule. The recent correction has helped bring equity valuations down from richer levels, and mid- to late- periods of an economic cycle can experience attractive returns. Diversification can become more important in this type of environment, including exposure to foreign assets, despite less than robust sentiment lately, with perhaps most of the ‘easy money’ already having been made in the U.S. recovery.