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Rebel Without a Pause: Fed Raises Rates, But Gets a Bit More Dovish

Rebel Without a Pause: Fed Raises Rates, But Gets a Bit More Dovish

Key Points
  • The FOMC moved as was generally expected, raising rates by 25 basis points and offering a slightly more dovish accompanying statement; albeit less dovish than some had hoped.

  • The Fed’s summary of economic projections were adjusted slightly, with both inflation and growth expectations lowered.

  • Emphasis was on the data dependency path the Fed will be on heading into 2019.

Although it wasn’t a forgone conclusion in the minds of some, the Federal Open Market Committee (FOMC) raised the federal funds rate by 25 basis points today, to a range of 2.25-2.5%, in a unanimous decision—the fourth time it raised rates this year. The Committee did pare back some of its projections for both interest rates and economic growth in 2019 and beyond. Specifically, the Fed now expects two hikes next year, down from three, while indirectly signaling they could pause their tightening campaign if incoming data so warrants.

Changes to the accompanying FOMC statement were minimal from last month, with the third one below most important:

  • The reference to the unemployment rate went from “declined” to “remained low.”
  • The word “some” was added to the language around “further gradual increases in the target range for the federal funds rate.”
  • Added to the assessment of risks to the economic outlook being roughly balanced, was “but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.”

The median FOMC estimate for the so-called long-run neutral rate fell from 3% in September to 2.75% in December. The median projection is for the fed funds rate to end 2021 at 3.1%, down from the September estimate of 3.4%.

Investors have been more pessimistic about the Fed’s path; expecting less than one rate hike in 2019. Coming into the meeting, and based on the fed funds futures market, there was only a ~70% probability of a rate hike today. That was the lowest probability heading into an FOMC meeting during this entire cycle, which began in December 2015.

Economic projection changes

Gross domestic product (GDP): The median 2019 projection was lowered to 2.3% from 2.5%; while the 2020 and 2021 projections were unchanged at 2% and 1.8%, respectively. The longer-run projection increased to 1.9% from 1.8%.

Unemployment rate: The median 2019 projection was unchanged at 3.5%; while the 2020 and 2021 projections each increased 0.1% to 3.6% and 3.8%, respectively. The longer-run projection fell to 4.4% from 4.5%.

Personal consumption expenditures (PCE): The median 2019 projection for headline and core PCE each fell by 0.1% to 1.9% and 2%, respectively; while the 2020 and 2021 projections were unchanged for headline PCE, and fell 0.1% each year for core PCE to 2.0%. The longer-run projection for headline PCE was unchanged at 2.0%.

Stock market reaction

After a strong start to the day, U.S. stocks pared their gains in the immediate aftermath of the FOMC announcement; likely due to the statement being less dovish than what had been expected. In addition, during the press conference, Fed Chair Jerome Powell made a comment that adjusting the pace of the Fed’s balance sheet reduction is not presently being considered. It was at that point the stock market’s decline accelerated. 

For what it’s worth, according to Strategas Research Partners, this is only the third hike in the past four decades with the trailing three-month, six-month and 12-month S&P performance negative. And hat tip to Ritholtz Wealth Management’s Josh Brown for this tidbit: the Fed has hiked rates 99 times since 1970, with this being the first time since then that the stock market was down 12% in between hikes.

Aside from what the Fed had been telegraphing, other possible reasons the Fed opted to hike rates today in the face of heightened equity market volatility/weakness could have been a desire not to be seen as bowing to political pressure and/or not wanting to link financial market volatility to financial system stability. At last month’s speech to the Economic Club of New York (which I attended), Powell made it a point to differentiate the two—suggesting that market volatility alone would not be a deciding factor for monetary policy decision making—and to emphasize that the data around the Fed’s dual mandate of price stability and full employment are most relevant.

Our takeaway

The Federal Reserve will become increasingly data dependent heading into 2019 and beyond. This is likely to mean every economic data point will be acutely analyzed. In addition, as we’ve been highlighting all year, unlike the first year of the Fed’s tightening cycle, financial conditions have also been getting tighter; while at the same time, the Fed continues to shrink its balance sheet. These continue to be ingredients in volatility’s recipe, which has been our mantra for about a year.

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