As was modestly expected by the market (~72% probability embedded in the Fed funds futures market), the FOMC unanimously elected to raise the benchmark rate 25 bps (from a 2.00-2.25% range to 2.25-2.50%) at today’s FOMC meeting.
The FOMC decision to raise rates came amidst elevated concerns surrounding future global economic growth and increased financial market volatility. This rate hike is the fourth interest rate hike this year (making 2018 the largest year of tightening since 2006) and takes the Fed funds rate to the highest level since March 2008. This marked the ninth interest rate hike of this current tightening cycle which began in December 2015.
Outside of the interest rate hike, below are some of the key highlights from the FOMC meeting as the Fed struck a less of a “dovish” tone than expected.
“Strong” Growth But Balanced Risks – Despite market angst as a result of continued uncertainty surrounding trade and fears of slowing global economic growth, the Fed acknowledged that economic activity continues to accelerate at a “strong” rate as household spending continues to grow “strongly” but fixed investment has moderated from its “rapid” growth earlier this year. The Fed highlighted that risks to their outlook are “roughly balanced” and that they will continue to monitor global economic developments. The Fed modestly downgraded its 2018 growth rate from 3.1% to 3.0% (which would be the strongest pace of annual economic growth since 2014) and downgraded its 2019 GDP forecast from 2.5% to 2.3% as tailwinds from pro-growth fiscal policy measures fade next year. Despite the downgrade to its 2019 economic growth forecast, the Fed expects economic growth in 2019 to remain above the long term potential growth rate of 1.8%. The Fed left its 2020 (+2.0%) and 2021 (+1.8%) growth forecasts unchanged.
“Strengthening” Labor Market – The Fed acknowledged that the labor market “continues to strengthen” and that job gains have been strong over recent months. As a result, the Fed left its 2018 (+3.7%) and 2019 (+3.5%) unemployment rate forecasts unchanged from the September FOMC meeting. This suggest that the Fed expects the labor market to continue to tighten throughout 2019. The Fed modestly raised its 2019 and 2020 unemployment forecasts to 3.6% (from 3.5%) and 3.8% (from 3.5%) but continues to believe unemployment will remain below the natural longer run rate (+4.4%) for the foreseeable future.
“On Target” Inflation – While inflation has moderated over recent months closer to the Fed’s target of 2% as a result of falling commodity prices, the Fed see little changes to longer-term inflation expectations. Given this, the Fed expects the Fed to remain near its symmetric 2% objective over next few years. As a result, the Fed lowered its 2018 core PCE forecast to 1.9% (from 2.0%) and its 2019-2021 forecast by 0.1% to 2.0% (from 2.1%). Chair Powell acknowledged that this inflation trend allows the Fed to be “patient” going forward.
Lowered Trajectory for Future Fed Rate Hikes – While inflation remains subdued around the Fed’s symmetric inflation target, the FOMC judges that “further gradual increases” in the Fed funds rate will be warranted and that policy at this point “does not need to be accommodative” given the strength of the U.S. economy. However, the Chair Powell acknowledged that there is a “high degree of uncertainty” regarding the Fed rate hike path and that the Fed will remain data dependent going forward. With respect to future rate hikes, in a more “dovish” measure, the Fed lowered its 2019 (to 2.9% from 3.1%), 2020 (to 3.1% from 3.4%) and 2021 (to 3.1% from 3.4%) median Fed funds forecasts from its September FOMC meeting. This suggests that the Fed expects to raise rates two times in 2019, once in 2020 and then remain on hold through 2021. With respect to the longer run, the Fed lowered the neutral rate to 2.8% (from 3.0% at the September meeting). This continues to suggest that the Fed will raise rates above the median neutral rate (2.8%) and shift the Fed into a restrictive policy stance in 2019 and remain restrictive through at least 2021.
While the Fed lowered its rate hike forecasts for 2019-2021, risk assets sold off following the FOMC meeting and press conference as Chair Powell remained committed to its policy normalization through both rate hikes and balance sheet run-off process. As a result, the S&P 500 declined sharply (-1.5%) to the lowest level since September 2017 after being up over 1% heading into the meeting. The 10YR Treasury yield declined (-7 bps to +2.75%) to the lowest level in eight months, thereby flattening the yield curve (10s-2s) to 13 bps. The dollar (DXY: -0.1%) remained down on the day but rallied off of the lows following the FOMC decision as the Fed signaled for further rate hikes.
With respect to future rate hikes, the futures market currently shows only 42% and 8% probability of one or two rate hikes in 2019, down from 71% and 35% respectively one month ago.
Outlook — The path of normalization continues
The FOMC meeting was within our expectation in regards to a 25 bps increase in interest rates and a constructive view on both economic growth and inflation. Despite the downgrade to 2018 and 2019 GDP forecasts, the Fed’s above trend forecast through 2019 is consistent with the elevated levels we have seen in confidence (consumer and business confidence rising to multi-decade highs) and manufacturing (ISM manufacturing near cyclical highs). With limited risk of recession on the horizon, solid economic fundamentals should allow for a further normalization in monetary policy via a gradual increase in interest rates and continued reduction in its balance sheet.
With respect to the trajectory for future Fed rate hikes, we continue to expect that the Fed will raise rates three times in 2019. This is a more aggressive path than the revised Fed dot forecast (two rate hikes in 2019) and current market expectations, as the market has priced in only one additional rate hike throughout 2019. However, the pace of Fed tightening going forward needs monitoring as the Fed funds rate rises above the neutral rate in 2019. The impact of the Fed’s tightening of monetary policy can be seen in financial conditions, as the Goldman Sachs U.S. Financial Conditions Index rose into “restrictive” territory for the first time since January 2017 this week. A more restrictive policy stance and tighter financial conditions could begin to slow the pace of economic growth and pose a headwind for risk assets.
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