December 20th, 2018

Morning Note

December 2018 FOMC post-mortem: gradualism is dead, long live the new gradualism!

  • The target federal funds rate was raised by 25bps to 2.25-2.50, bang in line with our call from November 2017 that there would be four hikes this year as the data would give Powell & Co no reason to pause. The effective ceiling of the corridor was lifted by 20bps as expected to 2.40. The ‘technical adjustment’ is meant to counter the runaway federal funds rate that wants to settle at and likely soon above the corridor’s ceiling.
  • Confirming our call from the November 26 Morning Comment, both the median and the bulk of the ‘dots’ for 2019 moved down to two hikes from three. We’re pretty confident about two hikes next year, though a few days of sifting through Fedspeak should tell us whether the risk is tilted towards less or more than that, or if two is indeed bang on (note that we stick with forecasting the Fed one year ahead).
  • The 2020 dot shifted to only hike from two: to a target federal funds rate of 3.1 from 3.4.
  • Interestingly enough, while long run GDP was raised slightly and long run unemployment lowered slightly, the estimate of long term neutral rate was cut to 2.8 from 3.0.
  • In the statement the Fed threw the markets a bone (two in fact): instead of saying that further gradual rate hikes are appropriate, now only “some further” hikes are appropriate. Furthermore, while risks are still roughly balanced, the Fed will “monitor global economic and financial developments and assess their implications for the economic outlook.” In plain English, the Fed finally officially acknowledged the slowdown in global growth and the tightening of financial conditions both at home and abroad.
  • With financial conditions tightening and global growth slowing, the FOMC cut its 2019 GDP forecast to 2.3% from 2.5%. That’s still clearly above the slightly raised estimate of potential growth of 1.9%. Unemployment and inflation forecasts were changed marginally.
  • The Fed still refuses to acknowledge the tightening of US money markets. Powell seemed to blame the high settlement of the federal funds rate and the secured overnight funding rate on increased T-bill issuance resulting from the fiscal stimulus. There were no signs that quantitative tightening will be slowed or stopped.

Having discussed the mundane stuff, we’d now like to mention a famous (or infamous) remark by an ECB central banker, namely the Lithuanian Governing Council member Vitas Vasiliauskas. Bear with us here.

Only two and a half years ago, when global growth was down and deflation fears were all the rage, Vasiliauskas famously said the following:

 “Markets say the ECB is done, their box is empty.” (…) “But we are magic people. Each time we take something and give to the markets — a rabbit out of the hat.”

Early 2016 was a very different world. The Fed and the ECB in particular were still obsessed with keeping financial conditions easy, almost at any cost. Everything needed to be done to boost stocks, lower real rates and exchanges rates as to prop up the real economy. Last week’s ECB meeting and today’s FOMC meeting in particular showed that we’re no longer in that world. Except tough love from central bankers, and that’s exactly what we got tonight.

Chair Powell, who most of the time still never really answers the questions, spoke a lot about how strong the US economy still is, and that the economy next year is likely to remain strong, albeit less strong than this year. And it is the “health of the economy” according to Powell that justifies some further hikes, market tantrums be damned. However, the data still has to confirm the forecasts before rates can be raised further. That was as explicit as Powell got. Markets – financial conditions – play a role here: more tantrums will likely weigh even more on growth, which in turn would call for an even slower pace of hikes.

In any case, we read Powell’s remarks during the press conference as not meaning that further hikes are on hold. It’s also not a ‘first do no harm’ approach, whereby the default outcome is no hike unless things are without a doubt getting better. Neither is it a ‘trial by error approach’ – these days the Fed is pretty certain about the effects of rate hikes. No, it’s simply the new gradualism whereby the Fed has more time to weigh the pros and cons of a rate hike. Right now the pros are the domestic economy and the labor market in particular. The cons are still lethargic inflation that remains slightly below target, and the global slowdown and financial market situation. But the “angst” among business that the financial market developments and trade tensions are causing, has yet to show up in the data, Powell emphasized.

One of the few strong hints Powell gave during the press conference was that policy “currently doesn’t need to be restrictive.” The federal funds rate is now at the bottom end of the FOMC’s neutral estimates. Reasonable people on the FOMC can disagree about whether or not one or two more hikes will make the policy stance ‘neutral’

For us a March hike is likely off unless the stars align so to speak: data beating expectations and the risk-off situation in markets reverting to something more buoyant. We’d put or money on the May meeting for the next hike, giving Powell & Co more time to take stock. Given no overt sign of an overheating economy and financial conditions tightening more than the Fed had expected (and which Powell hinted might be the result of Fed policy), our takeaway from today’s meeting is that the days of hikes at fixed quarterly intervals are over.