As I wrote yesterday, the Federal Reserve raised interest rates a quarter point but changed guidance in the face of tightening financial conditions. In his press conference afterwards, the Fed Chairman – also as predicted – talked bullishly about the near-term economic outlook. But, he also noted the tighter financial conditions and slowing global growth as two reasons for the Fed’s downshift regarding 2019. With only two hikes on the table for 2019, this now puts a March rate hike in question.
Even though the Fed threw the markets a bone, markets didn’t like the Fed’s hike and sold off. Some comments below
The Fed’s evolution
Jay Powell is incredibly plain-spoken. It’s easy to follow his reasoning. There’s no mumbo jumbo in his post-FOMC meeting press conferences as there was with Chairman Greenspan. And unlike Bernanke and Yellen, he is first and foremost a markets guy, someone who is not an academic economist. So he tends not to speak in the language of abstract academic economics.
If you listen to what Powell said today, I think the most important thing to take away is the data dependence of the Fed. This is what I heard Powell saying:
- 2018 has been a good year economically. So good that the Fed moved from guidance for 3 rate hikes to actually increasing rates 4 times.
- In the present day, things continue to be good, though the Fed, like most forecasters, expects some slowing in 2019, to levels still above the long-term GDP growth trend.
- However, since the end of September, financial conditions have tightened and global growth has slowed. This has caused a number of FOMC members to modestly downgrade forecasts. And as a result, the FOMC have also changed guidance for 2019 from three interest rate hikes to two.
- Going forward, you know the baseline median forecasts for both macro indicators and for the appropriate policy rate. The Fed will adjust their guidance only if incoming data deviate from those forecasts or other factors – like financial conditions and global growth – change to warrant doing so.
This is a bit of an evolution, one that dovetails with my own evolution on what the Fed was saying. Yesterday, I wrote that “I am now anticipating a change in the Fed’s guidance and language, so stark has the downshift in financial conditions been. At a minimum, I expect the Fed to point to tightening financial conditions as a headwind. When Powell speaks after the FOMC statement, I would expect him to show bullishness on the near-term economy but caution on financial conditions.”
That’s exactly what we got too. But just a week ago, I thought the Fed was less dovish.
“The macro data are still good though, both the data coming out about to present and forward-looking indicators about the near-term. And so that means we will get a rate hike when the Fed meets next week. The question, then, becomes, how and when will the Fed change guidance in order to hedge toward a pause. I don’t think anyone knows the answer to that question. My bet is that we won’t see any guidance language changes next week. But, we could do in January if the data are below par.”
Tightening financial conditions
And the reason for the Fed’s change – and my prediction that they would change – is financial conditions. Jay Powell talked about this in the press conference today. And what he said is that conditions have “tightened”. When pressed on what conditions, he refused to speak to specific markets. Instead, he pointed to the Fed’s watching a broad range of markets and determining what financial conditions are based on all of those markets.
The way to think about this is not in terms of a ‘Fed Put’ but in terms of the Fed’s reaction function to tightening credit and equity market access. The ability of companies, in particular, to raise capital for investment has been hurt by the recent market volatility. This is true both in terms of equity markets and debt markets. And, for me, capital investment is the critical factor that accelerates a slowdown into a recession. Powell seemed to acknowledge today that the Fed gets this. And that’s why it has paused.
What’s more is Powell pointed to exactly the episode I wrote about on Monday regarding the resiliency of the US economy. He talked about the Fed’s hiking in December 2015 and then pausing in 2016 until December when the shale oil capital investment crash threatened the US economy. He seemed to be saying, “we saw financial conditions tighten as firms had less access to capital. So we paused until financial conditions became looser.”
The chance of a 2019 recession recedes with this guidance
This is exactly what you want to hear from the Fed in terms of data dependency. Powell explicitly rejected any cause for the Fed to be rigid. He denied that the level of the so-called short-term neutral rate relative to its long-term cousin was meaningful in predicting what the Fed was going to do. He denied that the Fed was targeting specific markets like the US equities market. And he denied that the ‘dot plot’ should box the Fed into a specific policy position, instead relying on financial conditions and global growth as reasons for the Fed’s decision to reduce rate hike guidance.
On one level, this increases uncertainty about what the Fed is going to do. But, at the same time, it gives the Fed more flexibility to react to a wide range of incoming data. And to the degree that data show the potential for softening, the Fed has now shown it is as willing to pause under Powell in 2019 as it was to pause under Yellen in 2016.
So why did markets throw a fit, even though the Fed did exactly as I predicted it would? I think a lot of people were looking for more. In Monday’s market piece, I spoke about “the strange 31.1% implied probability of a Wednesday Fed rate hike pause.” That was just a crazy expectation for 31% of the people. In that same piece, I also spoke of a New York Times survey showing “CEOs thinking that the recession could begin in Q4 i.e. right now.” Again, bonkers!! Some people are just running very scared and expecting way too much from the Fed.
This is as good as it gets, folks. I went from thinking the Fed was going to stand pat on guidance for three hikes a week ago to expecting the Fed to ease off the brakes yesterday. And I suspect, the Fed’s change of heart from maintaining guidance to downgrading it was equally abrupt. The Fed looked at the data and acted. This is what you want to see. And given the likelihood of 2%+ growth in 2019, it makes recession because of policy error an unlikely outcome.
The yield curve did tighten on this move. So, the market may be trying to force the Fed further. The 2-10 year Treasury spread is now just 11.2 basis points. And that means a full inversion is just around the corner. This puts a March hike very much in doubt. When 2019 comes in just under two weeks, we will start to get a good feel for how the retail sales were. In the meantime, expect market volatility to continue. Uncertainty is still very high now. And until the market forces the Fed to pause, it will remain so.