The Fed hits the pause button

  • By Steve Miller

There was a plethora of analysis from the financial market commentariat in the wake of the Fed’s recent decision to keep the policy (Federal Funds) rate on hold at roughly 2.5 per cent.

That decision came after the Fed chose to raise the policy rate 4 times or a full 1 percentage point in 2018. Furthermore, at its last meeting for 2018, the Fed indicated that it planned to raise rates another 2 times or 50 bps in 2019.

In large measure that commentary portrayed the decision as a “U turn”, or a capitulation to President Trump’s incessant demands that the Fed desist from further interest rate increases, or a capitulation to increasingly panicked financial markets.

Some went further, arguing that the Fed was preparing to start an easing cycle as the economy travelled inexorably to recessionary territory.

In my view a lot of that commentary misses the point, both in terms of what the Fed did last year, and what it might do in 2019 and what that might imply for financial asset performance in 2019.

First, the process of exiting from the period of ‘unorthodox’ monetary policy was never going to be easy largely because it had never before been attempted.

What the Fed did in 2018 was in my view completely understandable: by enacting unfunded corporate taxes and throwing Congress a bone on expenditures, President Trump ushered in one of the biggest ever peacetime budget deficits and subjected the US economy to a massive ‘sugar hit’.

As a result, the US economy grew well ahead of trend and (happily) the unemployment rate fell to close to 50-year lows of 3.7 per cent.

While some of those elements are welcome, the flip-side was a sharp acceleration in leading indicators of inflation.

The New York Fed Underlying Inflation Gauge reached its highest level in 13 years. In that context, raising the policy rate to a still modest 2.5 per cent seems to me to be entirely defensible.

In my view a lot of that commentary misses the point, both in terms of what the Fed did last year, and what it might do in 2019 and what that might imply for financial asset performance in 2019.

Second, the landscape changed, and the Fed invoked that famous maxim made popular by the famous English economist, JM Keynes, which goes: “when the facts change, I change my mind; what do you do sir?”.

This more or less describes where the Fed got to when it met on 30 January. Among the significant “fact changes” in the economic and financial landscape over December and January were:

•    A big downdraft in risk markets in the December quarter;

•    Ongoing fallout from the US / China trade dispute;

•    A moderation in US economic growth and attendant diminution of inflation pressures;

•    The US government shutdown and the prospect that growth might be flat in the March quarter and have more enduring effects beyond that; and

•    A sharp slowing in growth outside the US, particularly in China and Europe.

In this context, despite indicating its predisposition to raise rates further, for the Fed to eschew the recent interest rate rise was what it should have done.

However, rather than signal a “U turn”, or some form of capitulation to the President or panicked markets, I think it is better characterised as a “pause”. After all, the key word used by Fed Chairman Powell to describe the Fed’s thinking was that it was “patient” in implementing its pre-existing plans for monetary policy. And bear in mind those plans still involve another 2 rate hikes this year!

Looking at the data flow since the Fed meeting seems to indicate that the US economy, at least in an underlying sense, is still going strongly.

Rather than signal a “U turn”, or some form of capitulation to the President or panicked markets, I think it is better characterised as a “pause”

The US Bureau of Labor Statistics released data for January showing the US economy added an impressive 304,000 jobs despite the US government shutdown, while the US Purchasing Managers Index, a closely watched indicator of manufacturing health, exhibited surprising strength in February, including strong increases in prices and forward orders.

So it may be that the US economy can eke out reasonable growth this year which, even if it is less than 2018, will be something around trend at close to 2 per cent.

With the economy at close to full employment this might mean that wages continue to grow, and inflation can creep upwards to above the 2 per cent level and that accordingly the Fed’s self-described “patient” approach is just that and not a “U turn” or capitulation of some sort.

This is not a forecast but more a plausible scenario, and I certainly wouldn’t want to downplay the aforementioned ‘headwinds’ that saw the Fed adopt a “patient” approach. But if it came to pass, what would be the potential consequences for financial asset performance?

First, it probably means that the bond rally runs out of steam but that yields move sideways to moderately higher.

Second, that notwithstanding the prospect of slightly higher bond yields, US equity markets eke out mid to high single digit gains from here, building on the solid rebound evident in January.

And such a scenario makes for a lot more agreeable investing environment for 2019.  


Steve Miller is an adviser to Grant Samuel Funds Management