We expect that the Fed will eventually adopt a “wait-and-see” strategy this year; we expect at most one more rate hike in 2019.
- The confusion with Fed communications in 2018 reflected its struggle to define a workable strategy for the next phase of the interest rate cycle.
- We expect that the Fed will eventually adopt a “wait-and-see” strategy in 2019. Such a strategy would build on many of the points Fed Chair Powell made in his Jackson Hole speech.
- We expect at most one more rate hike in 2019. If it turns out, as we suspect, that realized inflation continues to undershoot the Fed’s 2% target, then a “wait-and-see” strategy would translate into no more rate hikes this year.
- The Fed’s evolution toward the new strategy has been uneven, and it’s possible that the Fed will once more slip back into its old strategy of removing accommodation before finally and emphatically embracing the “wait-and-see” approach.
A Look Back at 2018: Confusing Communications
Exhibit 1: Overnight Interest Rates, 2-Year Forward
Stuck Between the Old and the New
While the Jackson Hole speech outlined one potential way forward, the problem has been that movement toward this new strategy has not been consistent. There have been more than a few instances when Powell and others have muddied the waters by seemingly reverting to an old strategy, or simply by being unclear about their commitment to the new one.
The December 2018 Fed meeting was one specific instance of being stuck in between the old and the new strategies. In a nod to the new strategy, the post-meeting statement softened the forward guidance by replacing “expects” with “judges,” a change that was meant to convey more uncertainty, Fed officials later explained. They also lowered their estimates of rate hikes in 2019 from three to two, and Chair Powell referred to “data dependence” on a number of occasions in his press conference. All of these changes pointed in the same direction, and suggested that the Fed was coming around to the “wait-and-see” approach that Powell described in Jackson Hole.
The confusing part, however, was that the Fed seemed unwilling to fully embrace the new strategy. Instead, the statement and press conference included a number of items that suggested the Fed was still stuck on the old strategy. Why, for instance, include any forward guidance at all? Why not just drop the guidance entirely, given that rates are now within the Fed’s estimates of neutral? If the strategy is to be truly data-dependent, why not show more concern about realized inflation falling in the most recent prints? Why not show more concern about the lagged impacts of the previous rate hikes? Investors who were looking for a more decisive statement were disappointed that the movement to the new strategy was not more definitive or emphatic.
Looking Ahead to 2019
First, a moderation in US growth will go a long way toward convincing Fed officials that monetary policy is in fact no longer accommodative. Overreliance on imprecise empirical estimates of neutral policy can lead to mistakes, Powell noted in Jackson Hole. Rather than empirical estimates, we suspect growth data will play an outsized role in shaping the Fed’s view on neutral policy. US growth surprised on the upside in 2018, leading Fed officials to suspect policy was easier than they previously estimated, and therefore that more tightening was needed. That process is likely to work in reverse as growth moderates. We expect growth to slow to a 2.0%-2.5% pace in 2019. As that moderation takes place Fed officials will be less confident in their estimates of neutral and will in turn be more cautious with interest rate hikes.
Second, inflation continues to undershoot the Fed’s 2% target, even as growth has outperformed and the unemployment rate has remained below 4%. The inflation undershoot calls into question the validity of the Fed models. Questioning the models is familiar territory for Powell, who has highlighted their inherent uncertainty, but in this instance it is the direction of the miss that really matters. Inflation has been consistently under the Fed’s target since the recovery started 10 years ago. In fact, since mid-2009 the Fed’s preferred inflation measure, Core Personal Consumption Expenditures (PCE) inflation, has only been above target for four individual months, and only one of those months was in the last five years.
Exhibit 2: Core PCE Inflation
Third, in the current environment we see the Fed’s overarching goal as protecting and extending the economic recovery. A recession in the next year or two would be particularly challenging for the Fed, as it would have to grapple with the trifecta of limited room to lower interest rates, an already extended balance sheet and uncertainty about fiscal policy support. This is not to say that the Fed wouldn’t respond appropriately, but just that it would be challenging. It would be much better, clearly, to simply avoid the recession and not have to count on its own ingenuity to find a way out.
Fourth and finally, the reaction to the December hike may serve as a small push toward adopting a new strategy sooner rather than later. Commentators from all sides of the economic debate have pointed out the weaknesses in the case for further hikes, especially given the muted inflation threat. The scale of the market reaction to recent Fed comments may also cause officials to take notice. That’s not because tightening in financial conditions has changed the outlook (any impacts are likely modest, at this point), but instead because the market volatility has underscored the uncertainty about the outlook. As Powell has said himself, when the outlook is uncertain, it’s best to proceed cautiously.
Chair Powell’s New Year
“Now when we get conflicting signals as is not frequently the case, policy is very much about risk management…First, as always, there is no preset path for policy.”
“And particularly with the muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves. But we’re always prepared to shift the stance of policy and to shift it significantly if necessary in order to promote our statutory goals of maximum employment and stable prices.”
“…and under Janet’s leadership, the committee nimbly, and I would say flexibly, adjusted our expected rate path.”
“…but what I do know is that we will be prepared to adjust policy quickly and flexibly, and to use all of our tools to support the economy, should that be appropriate, to keep the expansion on track, to keep the labor markets strong and to keep inflation near 2 percent.”
-Fed Chair Jerome Powell, Atlanta, January 4, 2019
These talking points are yet another step in Powell’s evolution toward a new “wait-and-see” strategy. Powell’s reference to “muted inflation readings” is an especially important point. By casting the realized inflation data in a starring role, Powell is consciously moving away from the forward guidance that had tripped up the market in December and moving instead toward a more truly data-dependent approach.
We Expect at Most One More Hike in 2019
A “wait-and-see” approach would elevate the significance of these headwinds to higher inflation. If it turns out, as we suspect, that realized inflation continues to undershoot the 2% target, then a “wait-and-see” strategy would translate into no more rate hikes this year. Showing more true data dependence, at least as it pertains to inflation data, may also help support inflation expectations, which have been under pressure as of late. A shift in focus to the inflation data cannot come too soon, in our view, and one hopes that it isn’t coming too late.
Our own preference would be for the outlook to be entirely dependent on the inflation data, and therefore no more hikes would be forthcoming. If the Fed were truly committed to a “wait-and-see” strategy right now, then the outlook would indeed be straightforward. But, as the experience of 2018 has shown, the Fed’s evolution to its new “wait-and-see” strategy has been neither as quick nor as direct as it could be. Chair Powell’s new talking points have recently moved the Fed in the direction we anticipate. These taking points will need to be sustained throughout the year, however, and it’s entirely possible that the Fed will once more slip back into its old strategy of removing accommodation, before finally and emphatically embracing the “wait and see.” In any case, we do think the Fed will get to “wait and see” eventually, and the strategy that Chair Powell outlined in Jackson Hole will define the next phase of the interest rate cycle.
The Federal Reserve Board (“Fed”) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The term forward rate is commonly used in both bond and currency trading to express today's expectation of the future value of either a currency or a bond. In bond trading the forward rate is an implied rate calculated from current interest rates on various bond maturities.
Forward guidance refers to the issuance of economic forecasts and policy plans by central banks to influence market expectations of future levels of interest rates.
Personal Consumption Expenditures (PCE) Price Index, or PCE Inflation, is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.
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