U.S. Federal Reserve Outlook For 2019: At Most One Rate Hike
Q&A with John L. Bellows, Portfolio Manager at Western Asset Management
You track the U.S. Federal Reserve (Fed) very closely. What are your expectations for 2019?
Our outlook for moves by the Fed relies on three main points:
- The Fed struggled in 2018, with its officials making contradictory statements about its assessments of the "neutral rate," which confused markets and spiked volatility.
- We expect to see clearer communications from the Fed in 2019 and believe it will adopt a data-dependent, "wait and see" approach.
- Our base case is for no hikes to the fed funds rate in 2019 given the low inflation rate, but we realize there is a risk the Fed will hike one more time anyway.
Looking back at 2018, what made communications from the Fed confusing?
Communications from the Fed in 2018 were rather confusing, but not about its near-term intentions. The Fed raised interest rates at every quarterly meeting. Each time the move was almost fully priced into markets well before the event. The confusion was instead about where policy would head over the medium term.
Fed officials equivocated on how far rates were from the neutral level; they vacillated on whether restrictive policy would eventually be warranted; and they obfuscated the substance of their data-dependent approach. Forward interest rate markets magnified these verbal gyrations: two years forward overnight interest rates moved from 2.2% in January 2018 to a high of 3.2% in October, before moving all the way back to 2.2% at the beginning of January 2019.
How do you think this affected investors?
Investors looking for a more decisive statement were disappointed that the movement to the new strategy was not more definitive or emphatic.
Do you think Fed Chair Jerome Powell might borrow from recent Fed chairs’ strategies?
No. In fact, the strategies used by Powell’s immediate predecessors have been made obsolete.
Chair Ben Bernanke's strategy was straightforward: with unemployment too high and inflation too low, monetary policy should be easy and support the recovery. Chair Janet Yellen's strategy was a little more nuanced, but easy to summarize: with unemployment and inflation closer to target, emergency accommodation was no longer needed and should be (gradually) scaled back.
Neither strategy will be of much use to Powell in the coming year.
Has the Fed given any indication what its new approach might be?
In his most recent Jackson Hole speech, Powell laid out one approach that could become the core of the Fed's strategy. He downplayed the importance of empirical estimates of the neutral policy rate and played up the importance of data-dependence – a "wait and see" strategy—by which officials would take their cues from realized data and, in particular, realized inflation data.
Such a strategy is reminiscent of former Chair Alan Greenspan's monetary policy in the mid-1990s. As Powell noted, Greenspan's strategy allowed the economic recovery to continue for a record 10 years and is considered one of the real bright spots in the history of U.S. monetary policy.
Has progress toward a new strategy been steady?
No. The problem is that movement toward this new strategy has not been consistent given Powell's apparent reversion to an old strategy, or simply by his lack of clarity about the Fed’s commitment to a new one. This has added to both uncertainty and market volatility.
In a nod to the new strategy, the Fed's December 2018 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 Powell referred to "data dependence" on several occasions in his press conference. All these changes pointed in the same direction — toward a "wait and see" approach.
However, the statement and press conference included items that suggested the Fed was still stuck on the old strategy. Why include any forward guidance at all? Why not just drop the guidance entirely, given that rates are 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?
What do you expect the Fed’s strategy will be in 2019?
We expect the themes from Jackson Hole will continue to work their way to the fore, eventually displacing the older strategies. However, the direction of the evolution of policy has been clear, and we expect a "wait and see" strategy will emerge as preferred over the alternatives, likely sooner rather than later.
What gives you confidence that this will be the likely approach??
Our assessment is based on four observations:
- A moderation in U.S. economic growth will go a long way toward convincing Fed officials that monetary policy is in fact no longer accommodative.
- Inflation continues to undershoot the Fed's 2% target, even as growth has outperformed and the unemployment rate has remained below 4%. This calls into question the validity of its own models.
- 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 because the Fed 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.
Reaction to the December hike may serve as a small push toward adopting a new strategy sooner rather than later. Commentators from all sides have pointed out the weaknesses in the case for further hikes, especially given the muted inflation threat.
How would you advise the Fed to proceed?
Our preference would be for the outlook to be entirely dependent on the inflation data, and therefore no more hikes would be forthcoming. While the Fed has struggled to come up with a workable strategy for the next phase of the interest rate cycle, the strategies used by Powell's predecessors have been made obsolete and will be of little use in the coming year. As economic variables are close to target levels and accommodation has been removed, Powell must now formulate his own approach – one that is better suited to current circumstances.
We believe it will be "wait and see," with clearer communications and at most one rate hike in 2019.
John L. Bellows, Ph.D., is a Portfolio Manager at Western Asset Management, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
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