January 31, 2019– Chairman Powell and the Federal Reserve pushed a message of “patience” after its meeting yesterday, meaning the central bank does not expect to raise interest rates for several months. This is entirely justified by the U.S. economic data, the slowdown abroad, and the numerous risks that lurk. The Fed also gave some more transparency about its willingness to slow down the ongoing normalization of its balance sheet. Equity markets were delighted by the news, moving higher on what had already been a good day. The Fed stance and the market reaction are warranted, but investors should not write off the possibility of a couple more rate hikes later on in the year.

The justified patience

First, no one expected the Fed to raise interest rates yesterday. This meeting was all about messaging. The slowdown in U.S. economic activity is ongoing, as we anticipated. After growth of roughly 3% in 2018, we have long expected a slowdown this year, but to a still-encouraging 2.25%, enough to push the cycle forward and continue to generate jobs. But the slowdown has certainly shown up in the data, especially in business capex. Importantly, inflation has slowed once again, in part due to the collapse in oil prices late last year, but also in some non-energy components. We don’t expect it to pick up until later in the year. At the December meeting, most members of the Fed committee decreased their expectations for rate hikes in 2019 on these same expectations of slower growth and lower inflation, and the median rate hike expectation is for only two rate hikes this year. Given the four hikes last year, the U.S. slowdown, the commensurate global slowdown, the “temporarily open” nature of the federal government, significant uncertainty about U.S.-China trade, Brexit, and the tumultuous ride in markets last quarter, there was no reason for them to hike rates this week. Chairman Powell referred to the litany of risks as “cross currents” that merited the patient stance.

But it would be a mistake to take the current dovish stance and assume the Fed won’t hike at all this year, or that it is completely done hiking rates in this cycle. Certainly if any of the risks, or some combination of them, push the economy into recession or create an international event that bleeds into the U.S. economy, the Fed would indeed keep the patient stance. But if risks are resolved in some reasonable way and the economy stays on track for growth anywhere in the 2.0%–2.5% range, the labor market will still be very tight, wages will continue pushing higher and inflation may rebound, all of which would lead the Fed to hike again later this year. (As we point out in our 2019 Capital Markets Forecast, we do not expect inflation to run rampant due to the influence of technology on productivity growth.) It is important to remember how quickly the environment can change. Just four months ago, before the start of the fourth quarter, the economy and financial markets were humming along, with very few people expecting the wild ride. It can change just as quickly—in the positive direction—between now and the June 19, 2019 Fed meeting, the earliest we think would be possible for a rate hike.

Oh, and about that balance sheet

For many in markets, the bigger news was the Fed making an official statement about its willingness to adjust the normalization of its balance sheet if things are going very badly in the economy or in markets. The Fed “printed” $3.5 trillion over the past decade to purchase Treasuries and mortgages to support the economy in the post-crisis era. For the past 15 months, it has been slowly reducing its balance sheet at a steady, announced rate by not reinvesting the proceeds it receives from Treasuries and mortgages that pay off. Some commentators in markets pointed to this action as the reason for the market volatility at the end of 2018.

The Fed has been trying to portray the balance sheet normalization as a non-active tool of monetary policy and would rather have the balance sheet normalization “running in the background” and as boring as “watching paint dry.” They really wanted to bring it down as far as possible without any adjustments, as if it could have been the major policy tool on the way up but somehow less important on the way down. But all of the attention brought to it recently forced the Fed to talk about it more openly, and admit it was willing to make changes if it thought the policy was damaging to the outlook or to markets. It was admitted first by Powell in multiple public appearances in December and January, and now in a more official capacity by the entire Fed committee.

When the Fed first announced the normalization policy in September 2014, it included a statement that noted a willingness to make adjustments. Not much attention was brought to this, as it didn’t want markets to be focused on two tools (interest rates and the balance sheet) on a meeting-to-meeting basis. In truth, the balance sheet has always been a monetary policy tool, and now the market made the committee say so. We think there is a fairly high threshold (significant economic weakness or financial market stress) for the Fed to make changes.

Core narrative

The Fed’s continued messaging of no rate hikes anytime soon is completely justified by the economic slowdown and the litany of risks. We don’t expect a hike until at least June. If the risks materialize in a bad way for the economy and markets, the Fed could be on hold for even longer, and may also stop the decline in its balance sheet. But if risks abate and the economy continues to expand, we expect more rate hikes in the second half of the year. We do expect the economy to keep expanding, but inflation to stay low. With the Fed on hold for now, this is supportive of risk assets and our overweight to U.S. equities.

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