Fed Hikes Rates, Market Tumbles

The Federal Reserve hiked rates as expected at December’s meeting while delivering a more hawkish message than Wall Street was hoping for. Equities tumbled and the yield curve flattened further as Federal Reserve Chairman Jerome Powell’s press conference wore on. I can’t imagine that the Fed is pleased with this outcome. That said, they have only themselves to blame. The Summary of Economic projections continues to maintain an unnecessarily hawkish bias that only allows Wall Street’s worries about growth to fester.

In retrospect, the outcome of this meeting is largely what would have been expected if you focused more heavily on the data flow than on the turmoil in financial markets. The Fed delivered largely according to my expectations, with a key exception: The Fed was more hawkish than I anticipated in that they did not drop entirely the “further gradual increases” language in the FOMC’s statement. I had expected them to create more uncertainty about the future; they chose instead to reinforce their expectation that rates would continue to rise.

Arguably, they were forced by their own forecasts to retain the language. To be sure, the revisions to the Fed’s forecasts were dovish in many ways. Expectations for growth, inflation, longer-run unemployment, and longer-run interest rates were all revised lower. But these dovish shifts failed to offset the fundamentally hawkish aspect of the forecasts: The forecasts continue to say that central bankers anticipate they will continue to raise rates until the Fed turns policy from accommodative to restrictive. It’s not just the median; the pattern of dots imply the same.

What’s going on here? The Fed is currently a slave to its own models. In simplistic terms, those models will revert in a predictable fashion to whatever supply side conditions are chosen by policymakers. Growth will slow toward trend and unemployment rise to its natural rate as policy rates rise into restrictive territory. It’s all a straightforward mechanical exercise.

That exercise, however, implies far too much certainty about the path of interest rates. That path is only valid in one particular future, but many futures are possible. Consequently, in the presser Powell tried to downplay the dots. This though is really almost impossible to do because no matter how you spin it the dots tell a clear story about the Fed’s expectations, and those expectations amount to a hawkish policy bias, and that’s a message Wall Street doesn’t want to hear.

I would say that Powell made the situation worse with this in the preamble to the presser:

What kind of year will 2019 be? We know that the economy may not be as kind to our forecasts next year as it was this year. History attests that unforeseen events as the year unfolds may buffet the economy and call for more than a slight change from the policy projections released today.

The implication here is that there is substantial downside risk to the economy. So much that the Fed is reducing its forecasts across the board. So much so that the Fed anticipates they will fall short of their inflation target yet again. And yet they continue to hike rates and signal more rate hikes to come.

It is an unnecessarily and explicit hawkish message that is an artifact of a communications strategy that only made sense when you could reasonably promise zero rates for an extended period. It makes no sense to create the impression of a promise to continue to raise interest rates at a mature point in the business cycle when growth is already slowing.

As for the rate policy itself, I tend to try to focus on what the Fed will actually do instead of what they should do. The latter at this juncture though likely impacts the former. My crystal ball is as fuzzy as any, but my instinct tells me this rate hike was more likely a mistake than not. It appears to be an overly mechanical reaction to the model outcomes.

My ace-in-the-hole for the US economy is that inflation remains low enough to allow the Fed to remain nimble. Or it had been. I don’t know what Wall Street is picking up; it isn’t in the macro data, which ultimately is why the Fed chose to press forward. But whatever it is has been going on long enough that it suggests caution is warranted. In a risk management framework, the Fed would have been wise to skip this meeting and put January in play. By not doing so, I fear the Fed may flip uncomfortably close to my alternative scenario – that they continue hiking until something breaks.

If this rate hike is a mistake, the rate hikes for at least the first half of 2019 will quickly fall off the table. My instinct tells me that should now be the base case. Eventually – and probably sooner than later – the Fed will realize they need to offset the Trumpian uncertainty. They won’t like it. But they will have to do it.

Bottom Line: The Fed hiked rates in a very predictable fashion. It might be a decision that quickly comes back to haunt them.