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Powell Preps Markets for a Pause

RFP
The Federal Open Market Committee (FOMC) is scheduled to meet for its last time this year on December 18-19. A rate hike at that meeting is all but a forgone conclusion, despite recent market volatility. The Fed is trying to bring rates up to a level that is more consistent with where we are in the economic cycle, not micromanage financial markets. The Fed is fairly confident that a rise in rates to a range of 2-¼ to 2-½% is consistent with that goal, as it will leave the inflation-adjusted fed funds rate close to zero, which has historically been stimulative to the economy.

That said, the Fed knows we are still in uncharted economic waters and doesn’t want to risk overshooting on rates now that growth appears to be slowing. In response, the Fed is expected to acknowledge slower, but still solid economic growth in its statement. Unemployment is stable and job growth this year has already exceeded last year’s. Some measures of inflation expectations have ticked down a tenth, mostly due to falling prices at the pump. That is something the Fed will likely discount, at least for now. The downward pressure on inflation from oil prices is expected to dissipate in the months to come.

Chairman Powell is expected to underscore the need for a more flexible trajectory of rate hikes going forward. His colleagues will help by shifting their expectations on rate hikes in the Fed’s “dot-plot” from a three for 2019 in September to between two and three in the December forecast. Another plus is that Powell will hold a press conference after every meeting next year, which will make every meeting “live.” While this has always been the case in theory, it has been overshadowed by the reality that in recent years the Fed has reserved rate hikes for meetings with a press conference to be able add context and clarify its actions.

The Fed’s forecasts are not expected to change dramatically, although I would not be surprised to see a few more downside outliers on growth. The Fed presidents are at the front lines of current trade skirmishes where they are seeing the casualties first hand. They are also starting to grow more concerned about corporate debt and the prevalence of “covenant light” loans showing up on bank balance sheets. The Board of Governors is also more concerned about the rise in riskier corporate borrowing seen in recent months. Even former Fed Chair Yellen flagged mounting corporate debt as a red flag for the Fed during a recent speech.

The minutes from this meeting, to be released three weeks after it occurs, are expected to reveal heated debate about the risks to the outlook. The number of downside risks discussed at the November meeting increased substantially from the September meeting. The Fed is also debating alternative ways to influence short-term rates, which could be formalized as a shift in how policy will be conducted in 2019.

Finally, there is the issue of the Fed’s balance sheet, which is now contracting at a much faster pace than we saw a year ago. The Fed has increased the pace at which it allows assets - mortgage-backed securities and treasury bonds - to mature off its balance sheet from $30 billion a quarter in late 2017, to $150 billion a quarter today. The Fed could shed $600 billion from its $4 trillion balance sheet in 2019 alone, putting upward pressure on long-term interest rates. If the economy slows more measurably than expected next year, the Fed will be forced to taper, if not stop, reductions in its balance sheet.

It is not clear that another round of asset purchases or “quantitative easing,” as it is called, would do much to stimulate the economy. That doesn’t mean the Fed wouldn’t try it if it believes it is necessary. Chairman Powell has also raised the possibility of going negative on rates in a recession, something the Fed resisted during the crisis.

Bottom Line
A December rate hike is pretty much in the bag. The Fed is not immune to the uncertainty that has plagued global financial markets, and will acknowledge the risks we face by signaling its flexibility in rate hikes. We have lowered our own forecast on rate hikes to two next year. The Fed will pivot quickly -- if need be -- to rate cuts.

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