As of late, it seems that there are two distinct sides to the US economic outlook story. On one side, we’ve seen a distinct change in tone from the Fed, shifting from a strong tightening bias, to somewhat more neutral/dovish, almost overnight. On the other, US data is (for the most part) roaring, continuing to point to a robust US economy, and one ripe to overshoot the Fed’s 2% inflation target. The Fed can’t have it both ways, which is leaving some in the market scratching their head. What’s going on here?
The FOMC’s latest rate decision on 30 Jan 2019 left the target range for the fed funds rate unchanged (at 2.25-2.5%, in-line with market expectations), however there were notable changes to the Committee’s outlook on the economy and their expected path for the policy rate. The Committee sees “muted inflation pressures”, suggesting they aren’t overly concerned with runaway inflation (despite their preferred measure, Personal Consumption Expenditure ex-Food & Energy recently hitting 2.0% in Q3 18 and having been on an upward trajectory since Q3 17). They have also done away with language suggesting that “gradual increases” in the headline rate would be warranted if the economy continues to expand, opting instead to be “patient”. Amongst other things, “international developments” are now also on the list of what to look out for.
This latest statement however, should not really come as a big surprise; the December 2018 Fed dot-plot showed the median Committee member expects only one hike for all of 2019, down from the two expected just three months earlier, with many concerned that Powell would begin to bow to Trump’s criticism and slow the pace of further hikes.
The FOMC held the line in December, sending equity markets tumbling into the holiday season – as one of my colleagues rightfully pointed out, this was probably one of the first Fed rate decisions prior to which Trump was not so vocally (and publicly) in Powell’s Twitt-ear – perhaps this was the Committee’s first opportunity to begin to exercise some caution, without fear of poor optics? Surely Powell does not want to be seen as the catalyst for an economic downturn, barely a year into his tenure… Looking to a couple of leading indicators for some direction, the US 10’s-2’s spread (which is the spread between the US 10-year and US 2-year Treasury yield) points to a flattening yield curve . Historically speaking, the inversion of the yield curve has been a precursor to each of the last five US recessions, usually leading by 6-12 months.
Source: Federal Reserve Bank of St. Louis
The Fed’s Beige Book released earlier last month suggested that despite tight labour markets and moderate price and wage growth, some respondents “had become less optimistic” in their outlook.
Taking a look at Fed Funds futures, market participants who had, just two weeks ago, equally weighted the probability of the Fed hiking or cutting rates before the end of the year (about a 20% probability of each), now expect no change in 2019, with only a slight chance (30%) of a cut in Jan 2020. With long-term yields coming off, some would say markets are flashing red, and that 2019-20 could bring a US recession, bringing an end to what has now been one of the longest (or near longest, depending on how you measure) business cycles in US history. Time doesn’t cause recessions, but still some food for thought.
On one hand, the Fed is signalling an end to their tightening streak, long-term rates are coming down, optimism is starting to fade, and blips in the equity markets are making investors nervous. On the other, unemployment is near all-time lows, wage growth is outpacing headline inflation (by a good margin), and many are concerned that inflation is ripe to play catch-up in the next few quarters. The first half of 2019 is surely going to prove interesting, particularly once the market has had an opportunity to digest the backlog of data released post-US government shutdown.