No News is Good News

Next week, the Federal Open Market Committee (FOMC) will meet for the first time this year. We expect the Fed to remain comfortably on the sidelines during this meeting. Look for the official statement to underscore the good news in the housing market while lamenting the weakness in manufacturing. The Fed could also note the threat posed by the coronavirus in China. The SARS virus caused a fairly sharp slowdown in growth in China 2003, shaving 2% off of GDP, with spillover effects for 37 countries. Now, China is much more connected to the rest of the world and has fewer ways to offset economic weakness.

We could see one dissent, in favor of a rate cut, among the FOMC members. President Neel Kashkari of Minneapolis has consistently argued that rates should be lower to boost wages and inflation more than we have seen over the last year. He has rotated into a voting position (for the first time in three years) on the FOMC and may want to take the opportunity to make his views heard. He would be alone in his dissent. This contrasts what we typically see with a dissent; a dissent usually reflects the view of the person voting and those of colleagues around the table who cannot vote.

Most within the Federal Reserve system are hoping to sit out 2020, but the threshold for a rate cut is still considerably lower than the threshold for a rate hike. Our view remains that the Fed will have to cut at least once in 2020 in response to what it sees as inflation that is too low. The Fed has been humbled by how weak wage growth remains despite the low level of unemployment and would welcome a little more heat in the broader economy.

What would it take for the FOMC to make another U-turn and raise rates? Chairman Jay Powell was fairly blunt at his press conference in December. He said that he would need to see a sustained period of overshooting on inflation before he raised rates again. We are still undershooting on the Fed’s inflation target today.

The Fed is in the process of reviewing its policy framework and is expected to come up with some tweaks to current rules later this year. My best guess is that the Fed will adopt an average instead of aiming for a symmetric inflation target, and provide a time frame for achieving its 2% target. Inflation has undershot that target since it was adopted explicitly in 2012.

The Fed will also discuss the size of its balance sheet, which it expects to continue to grow through at least April. A liquidity crunch last September prompted a sharp jump in overnight rates, which alarmed financial markets. It was a freeze in the overnight funding market - an unwillingness for lenders to hold any short-term debt - that triggered a credit crunch and surge in layoffs during the financial crisis. Borrowers who relied on short-term funding found themselves without the funds to make payroll.

Moves that the Fed has made to avert another problem appear to be paying off. There was no spike in overnight rates at the end of 2019, when many expected more problems in the overnight market. That said, it remains unclear how financial markets will react to any change in the Fed’s balance sheet. Many financial market participants believe that the liquidity provided by the Fed helped to boost stock prices above and beyond what rate cuts alone could do; any moves to stop that growth could show up as a loss in momentum for stock prices.

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