Setting The Doves Free

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.