Economic Insights - December 10 - 14, 2018
- Fed changing tack? Quarterly rate hikes may end after next week’s FOMC meeting. We expect (and hope) that the Fed will take a cautious approach next year. If they don’t signal a shift, the market will surely protest.
- Weekly highlights: With low gas prices and strong wage growth, this year’s holiday shopping season should be wonderful. The ECB ended its asset purchases, a first hike next year depends on a rebound in the data. Monthly numbers from China were weaker than expected.
- Investment implications: A Fed pause may dampen some of the market stress that we expect next year and would also benefit emerging markets.
Fed changing tack?
The Federal Open Market Committee (FOMC) may be moving away from this year’s quarterly rate hikes to another strategy. After a likely increase at this week’s meeting, the Federal Reserve (Fed) may pause.
The Fed may move to a more data dependent plan. According to the most recent FOMC minutes, the Fed wants to move away from “further gradual increases” to language that focuses more on incoming statistics. This shift aligns with the recent Fed speeches. On November 16th, Vice Chair Clarida stated, “...with the economy doing well it’s appropriate to sort of shift the emphasis toward being more data dependent.”
But is the Fed becoming more market dependent too? On October 3rd, Powell stated the Fed was a long way from neutral. Markets reacted swiftly and negatively. In November, Powell changed tune. He stated the fed funds rates “remain(s) just below the broad range of estimates of the level that would be neutral for the economy.” The neutral rate is the level of the monetary policy rate that is neither expansionary or contractionary for the economy.
We think that the Fed may take a breather at or just after the March meeting. There are plenty of reasons for a pause. First, the fed funds rate would be approaching some estimates of neutral. Three FOMC members think the neutral rate is 2.5%, the potential upper band of the fed funds rate at the March meeting. Four FOMC members think the neutral rate is 2.75%, the potential upper band of the fed funds rate if the Fed hiked in March. The trouble is that the neutral rate is unknown. The Fed may want to exercise caution as it gets closer to a potentially neutral rate. Second, inflation pressures have weakened. Core personal consumption expenditure (PCE) inflation is up only 1.1% on a three-month annualized basis. Oil prices and a stronger dollar will also likely be headwinds for inflation at least through the beginning part of next year. Market-based inflation expectations have dropped too. Lastly, the FOMC likely does not want to risk inverting the yield curve.
The market is increasingly calling for a March pause too. The market-based probability of a March hike has declined from nearly 60% in early October to around 30%.
With expectations of a March pause going up, the market will be looking carefully for a shift in tone at this week’s meeting. Moving away from the language “further gradual increases” may be one way to signal a pause. A change in the dot-plots, or FOMC members’ projected path in the fed fund rates, may also be a sign. The median FOMC member is calling for three rate hikes next year. If two members downgrade their views, then the median number of hikes shifts down to two. As the Fed gets potentially closer to neutral, it makes sense to shift strategy. If the Fed does not signal a change, the market will likely act like it did in early October, swiftly and negatively.
Happy holiday sales: US retail sales were up stoutly in November; core sales (retail sales ex-autos, food, gasoline, and building materials) grew 4.2% on a three-month annualized basis. October sales were strongly upwardly revised too. Redbook chain store sales have accelerated. With the sharp drop in gas prices and pick up in wage growth, the strength will likely continue in December. An enthusiastic consumer is a key reason why we think fears of the US growth slowdown are overrated.
It’s over: As expected, the European Central Bank announced an end to its asset purchase program. The ECB still stated that rates would remain unchanged through summer 2019. The bank did add reinvestment guidance, stating that it would reinvest securities from the asset purchase program well after beginning to raise rates. Despite the continued weakness in incoming data, the policy statement continued to emphasize that risks were “broadly balanced.” However, in his press conference, ECB President Draghi acknowledged that risks were shifting to the “downside.”
A hike next year really depends on growth. If GDP growth ends up between 1.5% to 2.0%, as we have been expecting, the ECB will still be on track to raise rates at the end of the third quarter. But if the recent growth stumble continues, the ECB may be forced to rethink.
Chinese slowdown continues: November retail sales and industrial production disappointed. Retail sales grew at the slowest year-over-year pace since 2003! According to Bloomberg, the weakness in retail sales may suggest that slowdown fears are weighing on confidence. We’d expect retail sales to reaccelerate next year as tax cuts start to take effect. If retail sales continue to fall that may suggest that the slowdown is worse than expected. In better news, fixed-asset investment spending did pick up slightly suggesting current stimulus may be modestly working.
A Fed pause may mitigate some of the down pressure on stock prices that we expect, but the end of easy money is still on track. The Fed shrinking its balance sheet and the ECB no longer expanding theirs, and that removal of accommodation will continue to cause market stress. A Fed pause may fuel emerging-market outperformance with less upward pressure on rates and the dollar. If the Fed continues to raise rates every quarter, they risk moving into restrictive territory and greatly exacerbating market turmoil.
The next Economic Insights will be published the week of January 7, 2019.