December 20, 2018 – The Federal Open Market Committee (FOMC) hiked the target Fed Funds rate as expected yesterday by 25 basis points from 2.25% to 2.50%.  The statement and press conference suggested that the outlook for the U.S. economy was one of decelerating but still solid growth, underscored by labor market tightness. However, it also highlighted, as we expected, that the Fed will likely have to slow its pace of hikes in 2019 and is more uncertain about the path of hikes going forward. While we expect this more dovish stance from the Fed should be supportive for the economy and equity markets going forward, the initial market reaction suggested investors had a different interpretation of the meeting.

The Fed acknowledges a softer outlook in its revised forecasts and statement language

Markets have been looking for a more dovish stance from the Fed in recent weeks for a number of reasons. Equity markets have pulled back sharply; credit spreads have widened; core inflation and longer term inflation expectations have moderated; commodity prices, particularly for oil are significantly lower; the yield curve has flattened; and global growth indicators have decelerated.

The FOMC has acknowledged many of these developments in a number of ways: lower expectations for future rate hikes, lower near-term GDP forecasts, and trimmed inflation projections.  Most importantly, it lowered its median longer run “neutral” estimate of the Fed Funds rate (the theoretical interest rate that would neither stimulate nor restrict the economy), by 25bp, to 2.8%, reiterating recent comments from FOMC officials that rates are “at the bottom end of the neutral range.” This suggests that the Fed could be closer to the end of its hiking cycle.

The Fed is as data dependent as it always has been—this should be supportive for equity markets

Given the fact that the futures market was pricing in roughly a 70% chance that the Fed would hike on Wednesday, along with our interpretation of the Fed’s statement as the committee being more cautious going forward, the downward pressure on equity markets is perhaps a bit puzzling (especially to Fed officials, who are frequently bewildered by market reactions to their policy changes and statements). The S&P 500 fell -2.5% on the day but finished roughly -3.25% off its intra-session high. The 10-year Treasury yield is back below 2.8%, and the yield curve is the flattest it has been in the expansion, with the difference between the 10-year Treasury yield and the 2-year yield less than 0.10%. We know the Fed will not (and, we would argue, should not) be deterred by what is by and large normal equity market volatility. However, their omission of a more pointed discussion about the indicators that have softened in the last few months may have fueled investors’ perception that the Fed is a bit tone deaf. In addition, the FOMC’s December “dot plot,” another term for its members’ projections, suggests that the Fed funds rate at the end of 2020 will be above its longer run estimate of the neutral rate, albeit by less than suggested by its September forecasts. Markets have taken this as a sign that the Fed still intends for policy to be restrictive going forward.

We would caution against a literal reading of the dot plot, as the median projection is just the midpoint of the range of forecasts given by each of the FOMC members based on their individual views and models, not a single consensus forecast that is voted on. Importantly, these forecasts are subject to change with new incoming data, so should not be interpreted as a direct signal of current or near term policy, as Chair Powell highlighted in the press conference. As an example, he pointed out that at the start of 2018, the median projection had originally only forecasted 3 rate hikes in 2018; however, that changed as incoming data showed the economy was stronger than originally expected, and we have in fact seen 4 rate hikes during the course of 2018.

In our view, the data dependence of the Fed should be supportive for markets, because recent data has taken a slightly softer tone and would justify a slower pace of hikes from the Fed (as our Chief Economist Luke Tilley outlined in a recent Wilmington Wire post).  We would note that the Fed is as data dependent as it always has been; what has changed is the data, not the way the Fed operates. In our view, the FOMC is mindful of these risks and willing to adjust their forecasts if and when the data reflects these headwinds.

Core Narrative

Though the market reaction to Wednesday’s FOMC announcement suggested disappointment and worries about a path of Fed hikes that will restrict growth, we believe that the FOMC’s communications  reflect a Fed that will be more reactive to any indications of a meaningful economic slowdown going forward.  Though tight labor markets indicate some continued tightening from the Fed is warranted, slowing inflation momentum will give the Fed increased flexibility to be more patient with their hikes, which we expect will extend the current cycle.

In terms of the real economy, the data continues to be solid, and we see the market as pricing in slower growth than we expect to see in 2019 and even 2020. Fed policy at this time should not yet be restricting U.S. economic activity; the inflation-adjusted fed funds rate is still right around 0%, meaning current policy should not inhibit businesses from growing their operations. We view the equity market as oversold and believe fragile sentiment, lower liquidity, and technical factors may be exacerbating volatility. At this time, we retain our conviction that the market will recover and head higher into 2019, spurred by a healthy consumer and solid economic activity. From an asset allocation perspective, we are slightly overweight to U.S. and emerging market equities versus our long-term strategic allocation, given attractive valuations and expectations for solid growth to materialize in 2019.

September FOMC participants’ assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate

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December FOMC participants’ assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate

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This chart is based on policymakers’ assessments of appropriate monetary policy, which, by definition, is the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her interpretation of the Federal Reserve’s dual objectives of maximum employment and stable prices.

Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant’s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. One participant did not submit longer-run projections for the federal funds rate.

Source: Federal Reserve

Data as of December 19, 2018

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