Tensions around U.S. monetary policy remain high as recession fears grow and markets seek further reassurance that the Federal Reserve (Fed) is prepared to slow or stop future rate hikes as needed. The Fed will meet this week and make a rate announcement on Wednesday, January 30. Policymakers’ last rate announcement rattled investors, who have watched global economic data deteriorate, but Fed Chair Jerome Powell’s comments on flexibility have calmed markets. Although the bulk of U.S. data remains solid, growing uncertainty over several issues leaves the Fed with a delicate balancing act as it decides its next policy steps.
The Fed’s signals on future policy at this week’s meeting will be especially telling. Fed policymakers raised rates December 19, 2018, but lowered their expectations in the “dot plot” (a summary of policymakers’ rate projections) to just two hikes this year. Still, U.S. stocks posted their worst performance on a rate announcement day since 2011 as investors interpreted the Fed’s messaging as detached from current economic reality. Since then, trade and political headwinds have intensified, and futures traders have increasingly positioned for a Fed pause this year. Fed fund futures are pricing in about a 70% probability that the Fed will keep rates unchanged for the rest of 2019 [Figure 1].
The Fed has acknowledged global risks but has maintained an optimistic stance on long-term economic growth, which is reflected in its updated dot plot. The median dot suggests the fed funds rate will rise to a range of 2.75–3% at the end of 2019 (or two hikes from the current level), then peak at 3–3.25% at the end of 2020 before declining to a “longer-term” rate of 2.75%. Based on the dot plot, the Fed is one hike away from this “longerterm” rate—or our best indication of the neutral rate, where policy is neither accommodative nor restrictive. Of course, the neutral rate is a moving target, and the economic factors the Fed watches are always shifting. But at this point, policymakers expect interest rates to settle around its forecasted levels, and they’re building in wiggle room to raise rates beyond neutral if inflation rises too quickly. The Fed updates its dot plot four times a year, so we’ll get more details on rate projections in March.
There’s broad consensus the Fed is unlikely to hike rates at this meeting, considering global weakness and signs of deterioration in pockets of the U.S. economy. Overall, though, we think the domestic economy is strong enough to digest continued gradual rate hikes once the trade and government shutdown headwinds subside.
POWELL’S TALKING POINTS
Powell’s post-meeting press conference will be another focal point. Powell is scheduled to speak after Wednesday’s rate announcement, based on the Fed’s new schedule of holding press conferences after every, rather than every other, meeting. Given Powell’s track record, this schedule change could be problematic for U.S. stocks. The S&P 500 Index has declined on every Fed rate announcement day since Powell took over as Fed chair in February 2018, although we do expect the tone in messaging to improve.
The latter part of the economic cycle has been challenging for every Fed chair, and despite Powell’s pragmatic approach to policy, the new chair has not yet found the right tone to persuade markets that the Fed will be responsive to circumstances even as it tries to contain risks of late-cycle inflation. Following the last meeting on December 19, the S&P 500 slid nearly 2% from the beginning of Powell’s press conference through the end of the day as he weighed in on softening inflation, deteriorating global growth, trade tensions, and the Fed’s political independence. Powell has tended to talk about the balance of upside and downside risks, and emphasized that the Fed remains flexible but data dependent. Even though Powell’s messaging hasn’t always soothed markets, we think his pragmatic approach is appropriate given the complicated nature of the domestic and global economy, and we don’t expect him to deviate from it.