The Fed gave markets participants all they could really hope for at the conclusion of the first FOMC meeting of 2019. Notably, the Fed shifted their guidance from further rates increases to patience, enshrining the recent Fedspeak in the FOMC statement and making clear that they Fed was in no rush to change policy and the next policy shift could be up or down. And if that alone were not enough, the Fed announced that they would likely be winding down the balance sheet run-off sooner than expected. Federal Reserve Chairman Jerome Powell came prepared avoid the missteps of the December FOMC meeting and markets rewarded him with a solid rally in stocks and bonds.

Where to next? The Fed is not committed to any particular policy path and will react as needed as incoming data impacts the forecast. Still, this feels like we are near the top of the rate hike cycle assuming the economy slows as anticipated.  

Interestingly, the Fed’s basic outlook remains fairly optimistic as I expected:

Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier last year.

Powell reiterated this point in the opening comments to his press conference:

This change was not driven by a major shift in the baseline outlook for the economy.

That’s interesting in that it suggests that the Fed’s SEP forecasts were fairly unchanged, possibly including the dot plot of rate projections. Luckily, however, since the SEP was not released this time, the statement and Powell’s press conference could be dot plot free and hence, more dovish overall (the dot plot is inherently hawkish, and it’s going to be a mess in March if the dot plot projections have not come down).

If the forecast didn’t change, what did? A number of factors, kind of a “lions, tigers, and bears” situation: Slowing global growth, Brexit, the partial government shutdown in the US, trade policy, tighter financial conditions, and weaker inflation expectations. Basically everything that has been weighing on financial markets throughout the final quarter of 2018 finally caught up to the Fed and caused them to be less certain in their forecast for higher interest rates.

The assortment of fears induce central bankers to drop their assessment that risks were balanced. That said, Powell’s opening statement sounded as if the risks were balanced to the downside. Specifially: “…the cross-currents I mentioned suggest the risk of a less-favorable outlook. As a consequence, the Fed no longer judges that further tightening will be required and instead:

In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.

“Patient” means that the Fed doesn’t need to commit to a decision on rates anytime soon. The Fed would argue that they have eliminated forward guidance; I would say the “patient” is forward guidance for the near term. A “patient” Fed isn’t going to return to the quarterly 25bp rate hikes at the March meeting.

In short, the statement was more dovish than I anticipated; I did not think they would want to take rate hikes off the table to this degree. I forgot that the Fed often turns their story later than I think they should, but when they turn, they turn quickly.

If that wasn’t enough, the Fed also updated their policy normalization guidance. They now expect to control short term interest rates via a floor system in a world with abundant reserves. The consequence of that decision is that the Fed believes they will maintain a larger than expected balance sheet, which in turn means the asset run-off will end sooner than expected. Powell took care to note that the balance sheet is not expected to be an active policy tool under normal economic conditions. The active policy tool is short-term interest rates. Still, many market participants were clamoring for the Fed to end the balance sheet run off sooner than expected. They got their wish.

As far as the future is concern, is this the end of the cycle? The bar for raising rates seems high now and apparently hinges on the inflation boogeyman to finally show his face. Powell said “I would want to see a need for further rate increases, and for me a big part of that would be inflation.” So they really need to see actual inflation, or very strong growth that pushes the unemployment rate substantially lower, to justify a rate hike. This appears much more stringent that the story implied by the last dot plot of interest rate projections.

To me, this sounds like the rate hike cycle is over – or largely over – as long as the economy eases as expected. The lack of inflation is keeping the Fed on the sideline now that rates are near their estimates of neutral. Going forward, the Fed may do some nips and tucks here and there to keep the economy stable which means that barring a sharp change in the outlook, we could be entering a period of fairly stable rate policy. I would add that a fairly flat yield curve suggests that market participants see the case for fairly stable policy as well.

Bottom Line: The Fed made a dovish shift, declaring that they are on the sidelines for the time being. Given that they seem to believe the downside risks are more prevalent, it is reasonable to think the bar to easing in the near term is much lower than the bar to hiking. Importantly, it looks to me that the Fed has shifted gears well ahead of any recession; then did not invert the 10-2 spread and then keep hiking as typically occurs ahead of a recession. A flexible Fed and the lack of inflation was always a saving grace for the economy. The Fed may have just pushed back the next recession. If so, expect everyone who expects an imminent recession to “blame the Fed” when that recession fails to emerge.

The Federal Reserve will leave interest rates unchanged at the conclusion of this week’s FOMC meeting. Any excitement that the meeting might bring will be contained in the statement and the press conference. The balance sheet will be of particular interest to market participants. The Fed’s challenge on that front will be communicating that should they slow the pace of balance sheet reduction, they will do so for technical reasons rather than as a shift in their underlying policy stance.

There is no question that the Fed will hold rates steady this week. Central bankers have made this abundantly clear by repeatedly stating that the Fed can afford to be “patient” when considering future policy changes. Now that policy rates are near the lower bound of neutral, the Fed believes they can slow the pace of rate hikes as they assess the impact of past policy actions. Policy thus has shifted to a more data dependent mode.

The statement will be searched for signs of dovishness with a focus on the Fed’s description of the economy and any expectations for the path of policy in the months ahead. The data flow of course was crippled by the now-concluded government shutdown. That said, I suspect the Fed will retain a fairly optimistic view of the economy.

Recall that the month began with an unquestionably positive jobs report. Moreover, initial unemployment claims provide no reason to think the labor market cracked in the first month of the year. Claims dropped to 199k, the lowest level since 1969 and pulling the four-week moving average down to 215k:

I am old enough to remember the recessionistas claiming that the uptick in claims in the final weeks of 2018 was of dire concern. Good times.

Industrial production has a strong showing in December despite the drop in the earlier reported ISM manufacturing report:

That said, regional surveys have on average suggested some ongoing malaise in the manufacturing sector while the Markit PMI measure firmed in January. Something of a mixed bag but I suspect the Fed will place the more weight on the industrial production report rather than the survey data.

The consumer sector of the economy is likely holding up despite the government shutdown. Consumer confidence slipped, but in my opinion that number had been elevated relative to actual spending since it jumped in the wake of Trump’s election. While we don’t have updated retail sales data yet, Redbook retail sales held strong with a solid year-over-year gain of 6.7% in the last week’s release. Also, Neil Dutta of Renaissance Macro, using Google search data, estimates that retail sales growth accelerated in December.

Housing remains something of a red flag that bears continued watching. Existing home sales dipped in December, likely weighed down by high prices, an earlier rise in mortgage rates, and increased uncertainty related to the stock market turbulence. That said, I suspect that slower price appreciation will allow time for income growth to improve affordability. In addition, mortgage rates have pulled back from their highs. On net then I don’t think that housing enters a deep, sustained downtrend in the months ahead. At a very basic level the lack of a substantial upswing in construction activity after the bubble-related collapse last decade means that the potential downside to the sector is relatively limited.

I think the Fed will on net conclude that there exists reason to believe that the economy will slow in 2019 relative to 2018 but the degree of slowing remains uncertain and not clearly sufficient to relieve inflationary pressures. As such, I doubt that the Fed will drop its internal bias toward further tightening before 2019 ends. That bias is clearly evident externally in the Fed’s Summary of Economic Projections. It is also evident in the statement with this sentence:

The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.

Will the Fed drop this sentence and end explicit forward guidance in the statement? I think the problem for the Fed is that dropping this language will be seen as a signal that the Fed is done raising rates for the cycle. In other words, lack of explicit forward guidance in the statement will be taken as explicit forward guidance nonetheless. I don’t think the Fed wants to send a signal that they are done hiking for the cycle and hence will need to retain some language that implies a tightening bias even if only implicitly. I also think the Fed is naïve to believe they can stop giving forward guidance. They can stop making promises about policy long into the future, but they will always find themselves providing at least near-term forward guidance.

Reporters will certainly pepper Federal Reserve Chairman Jerome Powell with questions about the Fed’s balance sheet. And just as certainly Powell will come more prepared for those questions compared to the December press conference. I suspect that he will have more clearly defined talking points on the topic. Indeed, I would anticipate a less “off-the-cuff” feeling in general for this presser.

The balance sheet is a tricky issue for the Fed. It is fairly clear that the don’t see the balance sheet reduction as a cause of recent market turbulence. They tend to think the decline in the balance sheet is a background technical issue. Hence central bankers don’t see the size of the run-off as particularly relevant for stance of monetary policy and focus instead on short-term policy rates.

That said, it is unfortunate that Powell was forced to admit that the Fed would of course change that pace of balance sheet reduction should the economy require such action. Very unfortunate really given that the Fed was already contemplating slowing the pace of the run-off for technical reasons related to the ability of the Fed to maintain effective control over short-term interest rates. From the December minutes:

Reducing reserves close to the lowest level that still corresponded to the flat portion of the reserve demand curve would be one approach consistent with the Committee’s previously stated intention, in the Policy Normalization Principles and Plans that it issued in 2014, to “hold no more securities than necessary to implement monetary policy efficiently and effectively.” However, reducing reserves to a point very close to the level at which the reserve demand curve begins to slope upward could lead to a significant increase in the volatility in short-term interest rates and require frequent sizable open market operations or new ceiling facilities to maintain effective interest rate control. These considerations suggested that it might be appropriate to instead provide a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve so as to promote the efficient and effective implementation of monetary policy.

Participants discussed options for maintaining control of interest rates should upward pressures on money market rates emerge during the transition to a regime with lower excess reserves…Some participants commented on the possibility of slowing the pace of the decline in reserves in approaching the longer-run level of reserves. Standard temporary open market operations could be used for this purpose. In addition, participants discussed options such as ending portfolio redemptions with a relatively high level of reserves still in the system and then either maintaining that level of reserves or allowing growth in nonreserve liabilities to very gradually reduce reserves further.

The communications challenge however, is this:

Several participants, however, expressed concern that a slowing of redemptions could be misinterpreted as a signal about the stance of monetary policy.

The idea of slowing the balance sheet run-off has only gained traction since the December FOMC meeting. See Nick Timiraos in the WSJand Victoria Guida at Politico. The ground has been laid.

My expectation then is that upon questioning Powell will open the door to slowing the balance sheet run-off as more than a theoretical possibility but will emphasize, or attempt to emphasize, that changes to the balance sheet policy do not indicate a change in the stance of monetary policy overall. Good luck with that though; I suspect that any indication that the Fed is winding down quantitative easing will be read as a dovish signal. Moreover, the Fed will come under fire for supposedly bowing to markets. I don’t think this is true, but that will be the perception.

Bottom Line:  The Fed will hold steady this week. I anticipate that barring any evident inflationary pressures, the Fed will be content to stay on the sidelines through at least the middle of the year. I think the underlying data will still prove too strong for central bankers to signal that they are at the end of the rate cycle. They will though want to communicate that regardless of their expectations, actual policy will be made with patience and flexibility. They will also want to communicate that the ultimate size of the balance sheet remains a technical issue at this point.

The Federal Reserve has positioned itself to sharply slow the pace of rate hikes this year. There even exists a scenario in which the December 2018 rate hike was the last of the cycle. That said, the Fed still anticipates the economy will need some additional tightening to reach their goals of low inflation and maximum sustainable employment over the medium term. Ultimately the path of rate hikes is data dependent, and that data yet to lead central bankers to the conclusion that rate hikes are now off the table.

With the December rate hike, policy rates at 2.25% to 2.5% now touch the bottom end of the 2.5% to 3.5% range of neutral rate estimates. Hence, policy may now be neither accommodative nor restrictive. Because of the imprecision of neutral rate estimates, however, policy makers do not know exactly the level of accommodation their policy provides. Consequently, they will need to rely even more heavily on the data flow as a guide to the appropriate policy stance.

Indeed, Federal Reserve speakers have made it clear that they will be very sensitive to incoming data in the months ahead. Last week, Chairman Jerome Powell reassured market participants that he recognized the downside risks reflected in recent equity price declines and, perhaps more importantly, that with inflation still low the Fed can afford to be patient before implementing further rate hikes.

What does this mean for the path of policy going forward? The ability for the Fed to remain patient means that in the near term there is no longer an immediate need to hike rates. While the Fed’s interest rate forecasts still anticipate another two 25 basis point hikes this year, those hikes do not need to be front loaded. The Fed can sit back and review its handiwork, waiting for the lagged impact of past rate hikes to filter through to the economy before taking further action.

That said, the data will still be relevant. The mix of data that keeps the Fed from hiking while retaining a bias to hike is best described as a combination signaling that growth will decelerate relative to the rapid pace of 2018, labor market outcomes point to fairly steady unemployment, and inflation remains low.

Recent data may be consistent with this story. The Institute of Supply Management index of manufacturing data slid in December, indicating that the sector still grows but at a slower pace than earlier in the year. The new orders index took a particularly large hit:

That said, the its non-manufacturing sibling revealed a much smaller decline while new orders held at high levels:

Countering the ISM manufacturing weakness, the employment report revealed a strong job market with a blowout gain of 312,000 employees for the month.

The temporary help component showed no reason to expect the job gains will end anytime soon:

And wage growth looks to now be sustainably higher:

I have to admit I am uncomfortable expecting the Fed to delay a rate hike until the middle of the year when employment growth remains on an upward trend. The only saving grace is that the economy delivered the workers necessary to keep pace with such growth.The unemployment rate actually ticked up to 3.9%, leaving it effectively unchanged over the past six months. In turn, continued stable unemployment will reduce the chances that the economy is overheating. Inflation is thus likely to remain in check.

Assuming December job growth is an outlier and will pull back in the following two months, the data flow will likely be sufficiently softer to keep the Fed from hiking in March – but they would retain a tightening bias and would likely hike again mid-year. This would be consistent with the forecasts presented in their Summary of Economic Projections. They will fear that eventually job growth that consistently exceeds 100,000 each month would eat up enough upward slack in the labor market to push unemployment sharply lower. They would be inclined to snug up a policy a notch to prevent that outcome.

If conditions arise that slows job growth toward 150,000, they will push any rate hike back further in the year. If the economy slows more than expected and job growth heads for 100,000, the Fed will move off the stage entirely.

Remember, these scenarios assume inflation remains contained. My general rule is this: The Fed will choose recession over inflation, but as long as inflation looks to hold sustainably near the Fed’s target, there will be a “Powell put” on the economy. That’s something to remember when wrestling with the recession calls that have grown louder in recent months. If you aren’t recognizing that absent inflation the Fed has the ability and willingness to cushion the economy against shocks that could threaten to send growth sharply lower than expected, you are doing it wrong.

Bottom Line: Low inflation means the Fed can move patiently. They don’t feel compelled to maintain the pace of quarterly rate hikes. Still, that doesn’t mean they won’t. My baseline expectation is that the data flow remains sufficiently soft and economic uncertainty sufficiently high to keep the Fed on the sidelines until at least mid-year. There is a chance of course that the correction in equity markets has left us all too pessimistic about the outlook for growth and inflation this year. If so, Fed commentary might turn hawkish again sooner than I anticipate.