Fed Chair Powell gave a boost to equities last Wednesday by saying the current Fed Funds rate is “just below the broad range of estimates of the level that would be neutral for the economy.” This is important as it suggests the Fed may be close to pausing its series of interest rate hikes. Over the last two months the markets have become increasingly skittish in the face of both rising rates and concerns over trade and slowing world growth. Through Friday, the S&P is down close to 7% since early October, and credit spreads are more than 25 bps wider.
Mr. Powell’s dovish comments came one day after the Fed’s Vice Chair, Richard Clarida, offered some detail on the Fed’s more accommodating rethink of the neutral rate, explaining that the Fed is close to meeting its twin targets of full employment and 2% inflation. Mr. Clarida added that labor markets may not be overheating, as some feared, since “there may be some further room for participation” by non-workers. Additionally, productivity growth is better this year, suggesting wages can continue to grow without pushing up inflation.
There is little indication inflation is a problem that requires higher rates. PCE (core) came out last Thursday at a below consensus 1.8% year-over-year. Looking forward, many economists are expecting growth to slow in the U.S. in 2019 as the impact from fiscal stimulus wains, previously enacted rate hikes begin to slow growth (look at the housing markets), and trade and tariffs increase costs, all while China and the rest of the global economy slows.
The credit markets widened modestly on the day, suggesting a less than dovish interpretation of the Fed comments. The credit market’s alternate interpretation of Fed comments is that a pause could signal that the Fed thinks economic prospects are weakening more than anticipated. If the economy is on the verge of slower growth, this is not good for credit.
Our in-house Fed policy discussions often center on the divergence between the Fed and the market’s anticipation of further rate hikes. How will this difference be resolved: will the Fed reduce its targets or will the market increase its expectations for rate hikes?
Maybe a release of the doves is a sign, but it won’t be the last!
Sources: Wall Street Journal, the Financial Times, Bloomberg, BMO Capital