Economic Insights - February 18 - 22, 2019
- Patient, but for how long? The January Federal Open Market Committee (FOMC) meeting moved markets. The Federal Reserve (Fed) shifted from wanting “some further gradual increases” to “patient.” The meeting minutes tell us more about what drove the Fed to change their policy stance and for potentially how long this change may last.
- Weekly highlights: The latest data from Japan and Europe point to a continued global growth slowdown. The Fed will review strategy this year, Vice Chair Richard Clarida indicates how they may change inflation policy.
- Investment Implications: The market hated the Fed in December but loved it in January. But stay tuned: The love may not last if the Fed hikes again this year.
Patient, but for how long?
The minutes revealed why the Federal Reserve (Fed) is taking a more cautious approach—the Fed wants more information. While the Federal Open Market Committee (FOMC) is happy with the US economy, the Fed wants to better understand risks and seeks more data on business and consumer sentiment and inflation. They want to assess how recent tightening of financial conditions and the government shutdown will affect the economy. FOMC members also want to determine how growth and inflation will react to monetary policy in place, to see how trade negotiations and growth slowdowns in Europe and China play out.
The Fed isn’t sure about the path of monetary policy for the rest of year. This uncertainty matters because, after the January meeting, a lot of investors expected the Fed to be on hold for the rest of the year. According to the minutes, many participants weren’t certain about “what adjustments to the target range for the federal funds rate may be appropriate later this year.”
Some thought the Fed’s next move would be a cut. The next move will likely be a rate hike. There was no discussion of a rate cut in minutes.
Inflation may be a deciding factor in the next rate decision, but the Fed is divided. “Several” thought a rate hike might only be needed if inflation surprised to the upside. “Several others” thought that another rate hike would be needed if the economy grew as they forecasted.
In addition, many FOMC members thought a patient stance may only be temporary. “Many participants observed that if uncertainty abated, the FOMC would need to reassess the characterization of monetary policy as patient and might then use different statement language.”
The most dovish part of the minutes dealt with the balance sheet. In December, Chair Jerome Powell stated the Fed would be on “autopilot” with respect to the balance sheet. But in a January statement, the Fed detailed that they would be willing to adjust the balance sheet based on economic and financial conditions. The minutes showed that the FOMC is coming to a consensus about stopping the Fed’s shrinking balance sheet this year: “Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.” In recent speeches, Loretta Mester and Lael Brainard confirmed this view.
Right now, the Fed feels that the risk environment warrants a patient stance to monetary policy. But if the Fed gets more clarity on risks, they may resume rate hikes. Global growth may improve as Chinese stimulus starts to boost growth. If the market rally continues, then financial conditions may ease more. Wage growth is accelerating, and at some point, that may work its way into inflation. The Fed may feel confident enough to hike by the end of the year.
Global growth update: Data is worsening in Japan. The latest business survey showed manufacturing activity contracted in February. Exports plunged over 8% year over year in January, the worst decline since 2016. While the Chinese New Year may explain some of the weakness, slowing global growth and a slowing China may also be to blame. South Korean exports were weak, another sign that global activity is still decelerating. Numbers out of Europe were mixed. Manufacturing surveys worsened for the Eurozone and Germany, though surveys for services improved. German GDP was flat in the fourth quarter after contracting in the third quarter. Yet, components of GDP weren’t as bad as the headline suggested. Inventories kept the economy from expanding. Consumer spending and business investment added to growth. Data suggests that the global growth slowdown that started last year isn’t over. But Chinese stimulus may boost growth by the second half of the year.
Is making up hard to do? The Fed is reviewing policy framework this year. In a speech last Friday, Vice Chair Clarida suggested that the Fed may change parts of its inflation strategy. It won’t change the inflation target from 2% but may change how it deals with prolonged periods of inflation misses, which policy doesn’t adjust for now. If inflation over- or undershoots the Fed target, they don’t make it up. This matters now as inflation has rarely been above the Fed’s 2% target since the financial crisis. The risk: If inflation stays persistently below target, then long-term expectations will drop.
So, as Clarida points out, some economists have advocated different types of “makeup strategies” including targeting average inflation or price-level targeting. These approaches are also supported by New York Fed President John Williams, former New York Fed President Bill Dudley thinks that the Fed will take one of these approaches. If the Fed does move to “make up” strategies, they will likely be more tolerant of inflation overshoots. All else equal, they may become more dovish. But this change in strategy will likely take time.
The market’s reaction to the Fed’s more patient stance has been wildly positive—though it may be too complacent about the prospects of a rate hike this year. The Fed took a dovish turn in January, in part, reacting to the sharp drop in December markets. If the market rally continues, the Fed may feel confident enough to hike by year-end. The market rally could be its ruin.