- Minutes of the Federal Reserve’s January meeting released on Wednesday showed that many risks the central bank had identified are materializing.
- This signals that the next move in interest rates is down, not up.
- The Fed stressed it will be patient amid uncertainty about the global economy.
After reading and re-reading theFOMC minutesfrom the most recent meeting at the end of January, my conclusion that the Fed is done raising rates for the cycle has been emboldened. Since I see many of the downside risks that monetary officials cited as morphing to reality, I continue to believe the next move in rates will be down, not up.
Here are the key takeaways:
- Both the Fed economic staff and the FOMC had believed at the time that growth was ‘solid’ to finish off 2018. We know now that the Atlanta Fed’s model has taken Q4 real GDP growth down to a mere +1.5% annualized pace, and the NY Fed for this quarter is now seen to be even weaker at +1.1%. The Fed had thought that consumer spending was still robust at the time of this meeting but this was prior to the news thatretail salesplunged 0.9% in December and was followed by a 5% slide in January auto sales. So the bottom line is that the economy was already in a deeper hole than the Fed had expected when this meeting took place. This means the output gap was less inflationary and the need for a completely ‘neutral’ funds rate less obvious.
- The Fed staff emphasizedoverleveraged corporate balance sheetsas an elevated risk to the outlook. And with that in mind, much of the downward revisions to the growth outlook seems to have come from capital spending — notice the choice of words with ‘delay or defer’ below.
- Much of the discussion at this meeting related to how muted inflation has been — a key fundamental surprise in view of tight labor markets. This wasn’t discussed, but this could be one reason why the estimate of the ‘neutral’ funds rate in the past four months seems to have been shaved to 2.5% from 3%.
- Downside risks to the economic outlook came from all sides — from Brexit, China and Europe, fromtrade, from the lingering effects of the tightening in financial conditions late last year. The waning of fiscal stimulus was also cited as a depressing growth factor, and this is baked in the cake.
- The only upside macro risk related to if the downside risks — and there are many — don’t materialize. That cannot be too comforting for the growth bulls.
- The Fed stressed ‘patience’ and for a number of reasons…related to a host of uncertainties, some of which may not be resolved for many months or quarters (what if Brexit and trade talks are kicked down the road?).
- I highlighted and underlined one key reason cited for ‘patience’, which relates to the lags between what the Fed has already done this tightening cycle (the equivalent of over 300 basis points of rate hikes) and the impact on the economy —“A patient approach would have the added benefit of giving policymakers an opportunity to judge the response of economic activity and inflation to the recent steps taken to normalize the stance of monetary policy.”
- To that end, it was equally interesting to see the emphasis on theflattish yield curve— with “several” stating that in“the past had often been associated with a deterioration in future macroeconomic performance.”The 10-year T-note yield is just 15 basis points away from slipping below the upper end of the Fed’s 2.25%-2.5% target band for the funds rate…would it really want to raise it again and invert the curve? Surely any thought to raising the funds rate would have to occur with medium- and long-term Treasury yields drifting higher from here, and commensurate to a rising inflation outlook.
- Indeed, this seems to be the only way that Jay Powell would push for another hike —“only if inflation outcomes were higher”than the baseline projection.
- In fact, an easing in policy is not even being viewed by some as out of the question —“many participants suggested that it was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year.”Note the word ‘many’ thinking that it is not clear which direction the next move could be — which is why I rolled my eyes when I read so many assessments of the minutes as believing that this was hawkish (or less than dovish) on rates. Only“several other participants”(as in, a minority) would be willing to tighten under the proviso that all goes well (as in, “if the economy evolved as they expected”…now how often does that ever happen?)
- There were several references to the financial markets and how policy has become ever so sensitive to how investors are behaving. In fact, the Fed openly pledged to take this into account in the future, so that Mr. Market knows that there is indeed a Powell Put (as has been figured out already in the first two months of the year).
- What the equity market may have really liked (while dismissing the litany of downside economic risks, which I suppose may have already been priced in late last year) was the suggestion that the Fed will cease in its QT policy, not at year-end but perhaps even sooner. As in,“later this year”and make the announcement“before too long”…the equity market, as we have seen, loves most tweets, dinners, photo opps and announcements.
The most important portions of the minutes
Below are some of the keyexcerpts— what I think is really important is in bold, and the things that are tremendously important are in bold and underlined.
Staff Review of the Economic Situation
The information available for the January 29-30 meeting indicated that labor market conditions continued to strengthen and that growth in real gross domestic product (GDP) was solid in the fourth quarter of last year..
Staff Economic Outlook
The U.S. economic forecast prepared by the staff for the January FOMC meeting wasrevised down a little, on balance, primarily reflecting somewhat lower projected paths for domestic equity prices and foreign economic growth. The staff estimated that U.S. real GDP growth wassolid in the fourth quarter of last year, bolstered by consumer spending and business investment, and that the effects of the partial federal government shutdown were quite small in that quarter. Real GDP growth was expected to slowbut remain solidin the first half of this year, with the effects of the partial federal government shutdown modestly restraining GDP growth in the first quarter and those effects being reversed in the second quarter.
Participants’ Views on Current Conditions and the Economic Outlook
Participants agreed that over the intermeeting period the labor market had continued to strengthen and that economic activity had beenrising at a solid rate.
Several participants commented that they hadnudged down their outlooksfor output growth since the December meeting, citing a softening in consumer or business sentiment, a reduction in the outlook for foreign economic growth, or the tightening in financial conditions that had occurred in recent months.
Participants noted that growth ofbusiness fixed investment had moderatedfrom its rapid pace earlier last year. Some participants highlighted that recent surveys of business sentiment or District contacts had indicated someweakening in optimism or confidence about the economic outlook, though available indicators suggested that the level of business sentiment had remained high.Concerns about the economic outlook were variously attributed to uncertainty or worries about slowing global economic growth, including in Europe and China; trade policy; waning fiscal policy stimulus; and the partial government shutdown. Manufacturing contacts in a number of Districts indicated that such factors were causing them todelay or defercapital expenditures. In addition, a few participants noted that recent declines in oil or gasoline prices had damped plans for capital expenditures in the energy sector.
In addition,manyparticipants commented thatupward pressures on inflation appeared to be more muted than they appearedto be last year despite strengthening labor market conditions and rising input costs for some industries.
In their discussion of indicators of inflation expectations, participants noted that market-based measures of inflation compensation had moved lower in recent months. Participants expressed a range of views in interpreting the decline in inflation compensation. On the one hand, that decline could stem from adecrease in expected inflation on the part of market participants. In that case, the current low levels of inflation compensation could suggest that inflation expectations are below the Committee’s 2 percent inflation objective. On the other hand, the decline in inflation compensation might reflect in large part declines in risk premiums orincreased concerns about downside risks to the outlook for inflation. This interpretation was seen as consistent with the behavior of the most recent survey-based measures of expected inflation, which were little changed.
Participants commented on anumber of risksassociated with their outlook for economic activity, the labor market, and inflation over the medium term.Participants noted that some risks to the downside had increased, including the possibilities of a sharper-than-expected slowdown in global economic growth, particularly in China and Europe, a rapid waning offiscal policy stimulus, or a further tightening of financial market conditions. An increase in some foreign and domestic government policy uncertainties, including those associated with Brexit, an escalation in international trade policy tensions, and the potential for additional extended federal government shutdowns were also cited as downside risks. A few participants expressed concern that longer-run inflation expectations may be lower than levels consistent with the Committee’s 2 percent inflation objective.Several participants judged that risks that could lead to higher-than-expected inflation had diminished relative to downside risks. The potential that various sources of uncertainty might abate more quickly than expected was mentioned as a potential upside riskfor the economic outlook.
Several participants also noted that theslope of the Treasury yieldcurve was unusually flat by historical standards, which in the past had often been associated with adeterioration in future macroeconomic performance.
Participants noted that financial asset prices appeared to be sensitive to information regarding trade policy tensions, domestic fiscal and monetary policy, and global economic growth prospects … Participants agreed that it was important to continue to monitor financial market developments and assess the implications of these developments for the economic outlook.
Participants pointed to a variety of considerations that supporteda patient approach to monetary policyat this juncture as an appropriate step in managing various risks and uncertainties in the outlook. With regard to the domestic economic picture,additional datawould help policymakers gauge the trajectory of business and consumer sentiment, whether the recent softness in core and total inflation and inflation compensation would persist, and the effect of the tightening of financial conditions on aggregate demand. Information arrivingin coming monthscould also shed light on the effects of the recent partial federal government shutdown on the U.S. economy and on the results of the budget negotiations occurring in the wake of the shutdown, including the possible implications for the path of fiscal policy.A patient approach would have the added benefit of giving policymakers an opportunity to judge the response of economic activity and inflation to the recent steps taken to normalize the stance of monetary policy. Furthermore, a patient posture wouldallow timefor a clearer picture of the international trade policy situation and the state of the global economy to emerge and, in particular, could allow policymakers to reach a firmer judgment about the extent and persistence of the economic slowdown in Europe and China.
Participants noted that maintaining the current target range for the federal funds rate for a time posed few risks at this point. The current level of the federal funds rate was at the lower end of the range of estimates of the neutral policy rate. Moreover, inflation pressures were muted, and asset valuations were less stretched than they had been a few months earlier.Many participants suggested that it was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year; several of these participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. Several other participants indicated that,if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year.
Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year. Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet. A substantial majority expected that when asset redemptions ended, the level of reserves would likely be somewhat larger than necessary for efficient and effective implementation of monetary policy; if so, many suggested that some further very gradual decline in the average level of reserves, reflecting the trend growth of other liabilities such as Federal Reserve notes in circulation, could be appropriate.In these participants’ view, this process would allow the Federal Reserve to arrive slowly at an efficient level of reserves while maintaining good control of short-term interest rates without needing to engage in more frequent open market operations.
David Rosenberg is a chief economist and strategist at Gluskin Sheff, the previous chief North America economist at Merrill Lynch, and the author of the daily economic report “Breakfast with Dave.” Follow him on Twitter@EconguyRosie.