The March FOMC meeting ended as many predicted—with no change to the fed funds rate, which is currently set at 2.25-2.50%. Regardless, the meeting was closely watched in terms of how the Fed planned to communicate a stance on policy for the remainder of 2019.
The formal statement noted a slowing in economic growth from the last meeting in January, including slower growth in household and business spending, while employment remained strong and inflation remained lower recently. The summary of economic projections, released quarterly, showed a downgrade in the ‘dot plots’ (which are generally averaged visually) to essentially zero implied rate changes for 2019, and perhaps only a handful at best over the next few years.
Investors were also watching for signs of a change in current or future policy regarding the runoff of the large Fed balance sheet (which it announced will taper off and in September). While the runoff had been described as being on ‘autopilot,’ fears have increased over an unreviewed runoff amount becoming excessive, essentially resulting in a ‘tapping of the policy brakes’ at the long-end of the treasury yield curve and perpetuating higher rates than ideal. One tweak is that maturing agency MBS will eventually be invested in treasuries instead—in keeping with the Fed’s preference for using treasuries as a purer policy tool and exiting the mortgage market, the participation in which was less ideal long-term as it implies a nudge toward helping housing markets (not part of the Fed’s mandate).
One very interesting development has been the change in Fed Funds futures market probabilities. Late last year, it was largely assumed the Fed would hike perhaps 1-2 times in 2019, a downgrade from the 3-4 many first expected based on the pace of rate hikes last year. As global uncertainty has increased, including the mixed bag of economic data showing deceleration in a variety of areas, this has since morphed into a market expectation for ‘no change’ this year, which has been in conflict with the Fed’s own estimates. Now, the tide has completely turned, with market probabilities for December showing 70% no change and 30% for a 0.25% or more rate cut. This would have almost unthinkable not that long ago, but worries over a possible slowdown into recession have begun to dominate market psyche. A variety of market strategists continue to believe the underlying economy is stronger than it looks, and could easily still handle a hike or two. Within reason, a few hikes could help the Fed with more ammunition to fight the next recession through room to cut rates at that time as needed.
Also interestingly, the Fed is reviewing its approach toward inflation targeting this year, and it is quite possible they could move toward an ‘averaging’ method. This would treat the 2% policy target as a multi-year objective, as opposed to a full-time anchor. What this means is if inflation were to run below target, such as during a recessionary period, it may be later allowed to run ‘hot,’ for example perhaps a half-percent higher than target during a subsequent expansion—resulting in a net result near target for the cycle as a whole. Such a method would give the Fed greater flexibility for interest rate policy, but not having been used up until now, we don’t know what any potential side effects could be from such a change. No doubt there will be more to come on this discussion.
The dashboard of key Fed mandates shows a little-changed story, despite what one might assume from the whipsaw in market sentiment over the past few months:
Economic growth: A decent portion of 2018’s economic growth was due to continued fiscal stimulus from tax cuts, which translated into unnaturally strong corporate earnings. This effect has faded, and, along with a notoriously difficult first quarter to predict due to bad weather, negative effects from the month-long government shutdown, as well as residual seasonality and other measurement challenges. GDP for Q1 is expected to fall somewhere in the 0.5-1.0% range, with improvement to 2.0-2.5% for the full year. (The Fed’s GDP forecasts were also lowered from about 2.25% to 2.00% this year, but kept at just below 2.0% for the next few years.) A moderated pace of growth would certainly act as a dampener to Fed tightening as well as to market interest rates in general.
Inflation: This also remains contained, with the February year-over-year CPI numbers coming in at 1.5% for headline and 2.1% for core (ex-food and energy). Oil price volatility has played a large role in the month-to-month headline differentials for sure, and upward pressure from rents and home prices have contributed to core inflation. Other areas, though, such as prices for autos, have weakened. With inflation numbers coming in near or below the Fed’s target, pressure to raise rates is lessened.
Employment: Despite less consistency in other economic data, labor is one area of persistent strength, to the point where almost every metric has remained solid—including a low unemployment rate, strong job openings, and low levels of jobless claims. This is despite the monthly headline nonfarm payroll numbers being a bit hot-and-cold, due to weather and adjustment effects. This would be the segment of the Fed’s mandate that could warrant a continued tightening to keep a lid on potential overheating. (The Fed downgraded their unemployment projection slightly by raising it by about a tenth of a percent, likely acknowledging the lateness of the cycle.)
What now? This question has likely been at the crux of the market’s bout with volatility since last fall. On one hand, while economic data has been decent in many areas, the ‘acceleration’ part of the cycle could be behind us, with further pressures stemming from a lowered global tide of foreign growth in Europe, Japan, and even China. While the U.S. economy is more insulated than many, a drop in global GDP still has a decent impact on the U.S. growth number. The trade uncertainties with China, as well as other idiosyncrasies like Brexit, also haven’t helped. On the bright side, however, earnings are still growing, albeit at a reduced pace, and the moderated level of interest rates have kept borrowing costs in check, which have aided a variety of assets including real estate. Risk asset prices have recovered from Christmas Eve bottoms, closer to ‘fair value’ levels at least in the U.S., and even cheaper abroad. Probabilities of recession have risen, but not in the immediate term and timing of these events are fluid and impossible to predict in advance. More than ever, a balanced asset allocation is a good insurance policy against a variety of less certain outcomes.