In recent weeks, there has been a major change in market expectations of Federal Reserve interest rate policy in 2019.
In early October, with chairman Jay Powell still sounding hawkish, markets expected that there would be three rate hikes of 25 basis points each next year, taking monetary policy decisively into restrictive territory. These expectations have now melted away and the forward markets show only one hike in 2019.
Recent signals from many Federal Open Market Committee members, including the most influential (Mr Powell, vice-chairman Richard Clarida, New York Fed president John Williams and governor Lael Brainard) have left little room for doubt that policy guidance will be changed when rates are raised one more time by 25 basis points at the meeting on 19 December.
Significantly, Mr Powell now refers to the policy of “gradual” rises in interest rates in the past tense, indicating that this phase of policy has ended. Several members of the FOMC have indicated that future rate rises will be “data determined”, removing any bias towards further increases, whether gradual or not.
With rates at 2.25-2.5 per cent after the December change, policy will be very close to the committee’s neutral range, centred around 2.5-3 per cent. After many years of forward guidance, the central bank will have returned to a more healthy condition in which rates are determined at each meeting on the basis of the latest incoming data.
Why has the stance of policy changed so abruptly? The following reasons have all been emphasised in recent speeches (which are summarised in detail in a new table attached here).
- The FOMC has recognised that its estimates of the neutral interest rate are inherently uncertain. In their view, this indicates that they should proceed very cautiously while they focus on hard evidence from the economy itself, enabling them to discern the stance of policy more accurately.
- Mr Powell has emphasised that monetary policy works with a lag of at least 12 months, implying that they will not know the impact of current policy until early 2020. This surely implies a lengthy pause.
- Recent monthly data suggest the underlying rate of core PCE inflation has dropped below target, despite the fact that wage inflation has moved up to 3 per cent. Mr Clarida, a credible and increasingly influential voice, has commented that inflation expectations are now towards the bottom end of his comfort zone. Since this is the Fed’s favoured measure of medium-run inflation conditions in the economy, this is an important statement.
- Financial conditions indices (FCIs) have tightened throughout 2018 as the dollar has strengthened, bond yields have risen alongside short rates and, lately, equity prices have plummeted. According to the most widely watched measure of the FCI estimated by Goldman Sachs, financial conditions have tightened by 90 basis points in the past year, which will slow the economy by almost one percentage point by the end of next year. The Fed probably thinks that enough is enough.
- Mr Clarida has suggested that the increase in the labour supply and in productivity might enable the productive potential of the economy to respond to rapid growth in demand for longer than anticipated without generating higher inflation. This would be a very significant development, and bullish for markets.
In view of this collection of evidence, the impending change in Fed guidance seems appropriate. However, it is also worth noting what has not changed in the economic and policy environment, to judge from the absence of any emphasis on these items by most Fed speakers.
- There has been no change in the Fed’s outlook for GDP growth, or economic activity, which is routinely described as strong or solid. This concurs with Fulcrum nowcasts, which remain above 3 per cent.
- Similarly, there has been no hint that the labour market is slackening. The November jobs data were slightly below expectations but unemployment remains at 3.7 per cent, well below the natural rate, estimated at 4.3 per cent. The FOMC believes that the Phillips Curve may have flattened, but they do not think it has disappeared entirely.
- There is little mention of the inversion of the yield curve (except from James Bullard). The yield curve is an indicator of future recession risk that is widely followed in the markets, but is not much respected by Fed economists. It is generally downplayed in policy discussions.
- Finally, and unsurprisingly, there is no mention of political pressure from US president Donald Trump, although the White House seems very gratified by the dovish tone of the Fed’s most recent statements. Nor is there any mention of the decline in equity prices or the rise in the dollar, and no real concern about instability in the financial system. These factors are apparently irrelevant for the FOMC, except through their influence on the financial conditions indicator.
Such is the febrile nature of recent economic commentary that there has been some discussion about the prospect that the 25 basis point increase in rates clearly signalled for December 19 might be postponed. There might be some support for this from fringe members of the committee, but probably little support from the leadership.
In the absence of a more obvious weakening in economic activity, this is seen as an over-reaction that could actually fuel fears that the Fed “knows something” sinister about the future of the economy. Although FOMC almost never has any decisive information that is outside the public domain, the market always suspects that it might.
What does all this imply about the actual path for short rates in 2019? Clearly, policymakers are in an increasingly dovish mood, and it would be unwise to bet against them at present.
However, they have not completely dug themselves into their present posture; far from it. As next year progresses, increasing tightness in the labour market may well lead to more wage inflation, and more rate hikes, than the market is currently pricing. This remains by far the largest downside risk to global markets in 2019.