Two-to-three additional rate hikes are forecast by the Committee. Risks however are growing in prominence.
Come their December meeting, the FOMC raised the benchmark federal funds rate by 25bps to a 2.25%–2.50% range. More important to the market however was the tone of the accompanying communications, which set the scene for 2019.
In the short decision statement, changes to the language around the economy were minimal. Data to hand indicates that the “labor market has continued to strengthen and that economic activity has been rising at a strong rate”. By sector, the FOMC’s description of the economy was also unrevised, with “Household spending [said to have] continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace [of] earlier in the year”. To the extent that the consumer makes up 70% of the economy versus investment’s 14%, continued strength in the former offsets concern over the latter – particularly as the starting point for investment growth was abnormally high.
The Committee’s quantitative forecasts to 2021 further highlight their belief in the underlying strength of the US economy. Through 2018, 2019 and 2020 aggregate growth is expected to remain above potential of 1.75% at 3.0%; 2.3%; and 2.0% – only marginally below the forecasts of September (3.1%; 2.5% and 2.0%).
Despite this robust view of the US’ economy however, the focus on “global economic and financial developments” in both the risks section of the statement and, more notably, Chair Powell’s press conference makes clear that “cross-currents” are increasingly giving the Committee cause for caution.
On global growth, Chair Powell was clear in the press conference that the Committee believe momentum has turned and that there are downside risks to the outlook. Chair Powell’s comments on this matter were kept very broad, but presumably key points of tension for the Committee include Europe’s economic slowdown and political tensions (including Brexit), and continued emerging market weakness – a function of trade tensions, higher US dollar interest rates, and now declining commodity prices.
In part because of this loss of global momentum as well as concern over higher US dollar interest rates, financial market volatility has clearly risen in recent months and become a much greater concern for the Committee. Arguably this is because the Committee is worried that, should it intensify further, this volatility could shock confidence amongst US consumers and businesses, and consequently beget a materially weaker growth outcome. To be clear, financial volatility is not a concern in and of itself; how it affects the real economy is the focus. Here there can be considerable lags, and so the Committee will have to deal with lingering uncertainty.
In addition to the potential confidence effect of financial market volatility, the ‘cash-flow consequence’ of changes in financial conditions are also front of mind. Since the September meeting, declining equity prices and a higher US dollar have tightened conditions for both US businesses and households. On interest rates: Treasury yields rose for a time, but have now reversed; credit spreads have moved wider however, and LIBOR higher. Looking ahead, to the extent that the Committee still sees two-to-three more hikes in this cycle, one has to expect that both US market interest rates and the dollar will move higher in 2019, and presumably credit spreads could widen further. Financial conditions are then set to remain in focus.
The FOMC clearly remains positive on the health of the US economy. Should their core view prove prescient, then two-to-three more rate hikes will be warranted. That being said, with headline and core inflation seen at target over the forecast period, and given the above “cross-currents”, having now reached the bottom of the estimated neutral range of 2.5%–3.5%, the FOMC will be more cautious ahead. To our view of three hikes and that of the Committee, risks are therefore skewed to the downside.
