Economic Insights - January 21 - 25, 2019
- Powell pause: We don’t expect any policy changes at this week’s Fed meeting. But, recent Fed speeches suggest that the Federal Open Market Committee (FOMC) could be on hold through at least the first half of the year. In coming meetings, the Fed may provide more details about when and at what level it will end balance sheet run off.
- Weekly highlights: European economic activity is not improving, and the European Central Bank (ECB) is taking notice. Chinese output may be stabilizing. Jobless claims hit a near 50-year low.
- Investment implications: The year-to-date rally could bring about its own demise. If markets continue to do well, the Fed may feel confident enough to end its pause by yearend.
FOMC members have coalesced around a “patient” monetary policy stance this year. On January 4th, Jerome Powell stated, “with muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves. St. Louis Federal Reserve President James Bullard, Boston Fed President Eric Rosengren, Chicago President Charles Evans, and even hawkish voting member Esther George used similar language in recent speeches. The December meeting minutes align with this language too. The minutes stated, “many participants expressed the view that, especially in an environment of muted inflation pressures, the Committee could afford to be patient about policy firming.”
The Fed may want to be cautious going forward as the fed funds rate approaches neutral. Neutral policy is neither accommodative nor restrictive. At between 2.25% and 2.5%, the fed funds rate is at the bottom range of FOMC members’ estimates of neutral. But, the neutral fed funds rate is not observable. So, the Fed may not want to risk unintentionally moving into restrictive territory.
The Fed has room to take a breather because inflation pressures aren’t mounting. Market-based inflation expectations have rebounded off their recent low but remain muted compared to the last year. Headline CPI inflation will likely decline with the recent fall in gasoline prices. Wages are increasing, but unit labor costs have been decelerating. Unit labor costs are a good predictor of future inflation.
Slowing global growth also suggests that the Fed will pause. The December FOMC statement added, “…will continue to monitor global economic and financial developments and assess their implications for the economic outlook.” Since the meeting, incoming global economic data have not improved. European and Chinese businesses surveys worsened. Germany likely barely avoided a fourth-quarter contraction.
Powell will likely be asked about the Fed’s plans for the balance sheet. At the December press conference, Chair Powell stated that the Fed would be on autopilot with respect to the balance sheet. Markets reacted negatively. In early January, Powell stepped back from that language. In another speech, Powell did emphasize that the balance sheet would be sustainably smaller. A last Friday Wall Street Journal article hinted that the Fed may end its balance sheet reduction more quickly than expected. According to the article, the Fed may feel more comfortable with a large amount of reserves in the market and elevated reserves could keep money market volatility constrained.
While we think that the Fed will pause through at least June, it’s unclear what they will do in the second half of the year. Inflation will probably stay muted, giving the Fed some leeway. So, their decision may boil down to financial conditions and global growth. If the market rally continues, then the Fed may feel more comfortable resuming rate hikes by the end of the year. Stimulus may also start to boost the Chinese economy, reducing downside risks to global growth. But, if there is another downdraft in markets, that may be enough to keep the Fed on pause all year.
No rebound in sight: After new emission standards hit German auto production in the third quarter, many had hoped for a bounce back in European data. However, January Purchasing Manager indexes (PMI) generally moved in the opposite direction. France’s composite PMI and Germany’s manufacturing PMI moved below 50.0, signaling contraction.
At its policy meeting, the ECB acknowledged the worsening data, stating the “risks surrounding the euro area growth outlook have moved to the downside…” With data not improving, the chance that the ECB stays on hold this year has increased. The policy statement’s forward guidance did not change, the ECB stated that they will keep rates on hold through the summer of 2019. But, statements from Draghi suggested that the ECB may be on hold for longer. He stated, “When markets place the first rate hike in 2020, they are using the state contingent part of our forward guidance. They assess the prospects that way and it shows they have understood our reaction function.”
Worst in almost 30 years: China grew 6.6% in 2018, the worst pace in 28 years. According to J.P. Morgan calculations, GDP grew 6.1% on a quarter-over-quarter seasonally adjusted annual rate in the fourth quarter. However, the December monthly data point to tentative signs of stabilization. Industrial production and retail sales growth picked up as fixed-asset investment spending steadied. We expect the government to continue to add stimulus, whether it be more tax cuts or reserve requirement ratio cuts to buoy growth this year.
Jobless Claims Near 50-year low: Jobless claims declined to 199,0000, the lowest level in 49 years. Federal employees are not included in headline jobless claims, but any laid off private contractors would be included. Jobless claims for federal employees have increased from around 900 the week before Christmas to over 25,000 the week of January 11th. During the 2013 shutdown, jobless claims for federal employees spiked to 70,000. Jobless claims have been trending down since late November. Continued low jobless claims suggest that the February jobs report will likely be healthy.
A more dovish Fed tone fueled the year-to-date rally. But that very rally could encourage the Fed to start raising rates once again later this year. Then, the volatility that hit markets last year could reassert itself and put upward pressure on the dollar. However, if the Fed decides to keep the balance sheet larger than expected, that could boost risk assets. The ECB potentially being on hold through 2020 will likely keep downward pressure on European rates and, in turn, US rates.