Fed View: Dovish shift suggests a prolonged pause – Comments from Fed officials in recent weeks have provided further confirmation of a significant dovish shift on the FOMC. This has occurred not just among the centrist leadership on the Fed board, but also the hawks. For instance, Cleveland Fed president Mester – among the most hawkish until recently – said last Friday that she did not ‘feel an urgency to increase rates’ and that ‘we have to take into account that financial market conditions have tightened’. Indeed, tighter financial conditions (driven chiefly by equity market weakness), alongside mounting downside risks to the global economy, are the primary drivers of this dovish shift, in our view.
Accelerating wage growth alone unlikely to trigger more tightening
As a result of this shift in signalling from the Fed, and our view that the economy is on a cooling trajectory, we have removed the last remaining hike we had forecast for this year (as recently as November, we had projected two 2019 hikes). As Chair Powell has emphasised, the fed funds rate is already at the lower end of the range of estimates for neutral. For the Fed to resume rate hikes and to take rates into potentially restrictive territory, we believe one or both of two conditions would need to be fulfilled: 1) growth picking up again to rates well above potential (c.1.8%), 2) core inflation showing sustained signs of acceleration. We do not believe accelerating wage growth alone will be enough to push the Fed to tighten further.
But rate cuts also look unlikely
Atlanta Fed President Bostic said today that the ‘next rate move could be up or down’ and would be ‘driven by the data’. While this appears to have weakened the dollar, we think it merely emphasises that Fed policy will be more data dependent from hereon, and we note that in separate remarks on Monday Bostic said that he expects one more rate hike in 2019. Indeed, we believe the tightening bias will be maintained by the Fed (i.e. the dots will likely still show one or two rate hikes on the horizon), and that the bar will be high for the Fed to shift to an easing bias and to start cutting rates. For this, there would have to be a meaningful risk of the US entering a recession. On our forecast horizon – to 2020 – we think this is unlikely. While the investment cycle has likely peaked (as pointed to by the recent dramatic fall in the ISM), and there are risks in corporate debt for instance, private consumption should remain solid, and – the current shutdown notwithstanding – government spending is projected to increase sharply in 2019. These factors should keep growth somewhat above trend over the coming year, offsetting the softening in manufacturing and investment (see our US Outlook 2019 for more).
What about the balance sheet?
Chair Powell last Friday signalled more flexibility on the balance sheet runoff than he had until recently, stating “If we ever came to the conclusion that any aspect of our plans was somehow interfering with our attainment of our statutory goals, we wouldn’t hesitate to change it, and that would include the balance sheet.“ The Fed has been at pains to downplay the impact of the balance sheet runoff, and has indicated consistently – both in public commentary and in the FOMC minutes – that its preference is for interest rates to be the primary tool of monetary policy, because rates have a more clear and direct impact on the economy. However, should recession risks materialise, it would look odd for the Fed to reduce rates while continuing to allow its balance sheet to run down. That Chair Powell has indicated more flexibility in public suggests this could become a key topic of discussion on the FOMC in the coming months.