20 December 2018
The Federal Reserve’s decision to hike interest rates at its December meeting was probably one of the more controversial decisions of the current tightening cycle.
Only a few weeks ago, Chairman Jerome Powell projected high confidence in the state of the US economy and the path of gradual rate increases.
“There is no reason to think that the cycle cannot last for a while, practically forever”, he declared in one of his speeches in October. Shortly after this speech - literally the following day, to be precise - equity markets finally gave in to all the concerns related to global growth and geopolitical uncertainties, which also coincided with sharp falls in the oil price and a growing realisation that the above-trend US growth is not sustainable for much longer. The resulting tightening in financial conditions and some weaker US data led the Fed to shift to a more dovish, data dependent stance over subsequent weeks.
Powell still upbeat on economy
While Chairman Powell reinforced this message to some extent at the December press conference, the overall stance was on the hawkish side, which surprised the markets.
Powell chose to strike a relatively balanced tone, still sounding upbeat about the economy while recognising increased risks from tighter financial conditions and continued slowdown in global growth. This was in line with the FOMC statement which contained very few modifications, sticking to the ‘strong economy’ narrative while slightly moderating the language around further rates increases.
The drag from tighter financial conditions resulted in a slight downgrade to the 2019 growth forecast which nevertheless remained above trend. The influential ‘dot plot’ also contained one fewer hike projected for 2019, now amounting to two interest rate increases for the year, instead of three previously.
'Pause and re-assess’ strategy would serve Fed well
In my view, the Fed’s assessment of the economic outlook for next year is still somewhat too optimistic. I expect the US economy to slow to around 2 per cent or just below that in 2019, which is far from recessionary and roughly in line with trend but below the Fed’s forecast.
I believe a ‘pause and re-assess strategy’ at some point next year would serve the Fed well. With some one-off data distortions in a number of important global indicators in the second half of 2018, including data from China and the Euro area, more clarity is needed on the direction for the global cycle, and this in turn would help set the tone for markets.
More importantly, the Fed has to evaluate the effects of the fading fiscal stimulus combined with the recent tightening in financial conditions on the economy. These existing headwinds might well be sufficient to prevent the much-feared overheating, releasing some pressure in the labour market.
Another complicating factor is the ongoing unwinding of the balance sheet the effects of which are still largely unknown. While so far the Fed has kept this process ‘running on autopilot’, they will likely have to address the issue in a more active manner in 2019. This would almost certainly imply less tightening via interest rates, not more.
Small misstep could override achievements
Unwinding the most unconventional monetary policy experiment in modern history was never going to be easy. To its credit, the Fed has managed the policy normalisation process relatively smoothly so far.
But at this point of the cycle, a small misstep could override the achievements to date. Pausing to evaluate the situation, even if it results in overshooting inflation target - which is still a big ‘if’ - would not be as costly as overtightening and bringing the economic expansion to its end.
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