The Fed is the Christmas Grinch

 

Matthew Peter, Chief Economist

This week, the Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) met for its last meeting of 2018. At the meeting, the Fed raised the target band of the fed funds rate from 2.00%-2.25% to 2.25%-2.50%, as anticipated by the market and most forecasters (QIC included). However, the Fed failed to assuage market fears that it would continue to push ahead with its program of monetary policy normalisation (meaning higher fed funds rates and a shrinking of the Fed’s balance sheet), leading to another sharp sell off in equity markets.

The underlying problem facing the Fed is how to balance the divergent signals emanating from the real economy and financial markets in a way that avoids the panic we are seeing across financial markets. As we wrote in last week’s Brief (Recession: what the professionals are saying), while the economic data show signs of a slowing in economic growth from their above-trend rates of the first half of 2018, the outlook remains robust and some distance from recessionary settings; even over the medium term.

But this is not what financial markets are seeing. Since the end of October, the US equity market has fallen by 16% (as measured by the S&P 500), within striking distance of the first bear market in US equities since the GFC.

However, the pessimistic view on the economic outlook is more forcefully expressed in fixed income markets. As if the drop in sovereign bond yields since the start of October were not enough (-40 basis points (bps) on the 10-year yield), US yields have been inverting along the 2-year to 5-year section of the curve for almost a month now, with the possibility of the inversion rolling out to the 2-year to 10-year section of the curve in the New Year.

The inversion of the yield curve is often the harbinger of recession and reflects fixed-income investors’ expectation that the Fed will make a policy mistake and have to reverse some of the rate hikes it has made. We can observe market expectations on the future of monetary policy in futures implied fed funds rates.

Currently, the futures market is pricing a 40% chance of another 25bp rate hike by the Fed in 2019. However, it is also pricing that the Fed will have to unwind the hike in 2020.

While the ongoing robustness of the economic data may provide some comfort, there will be significant fallout if financial markets continue to deteriorate. The conduct and communication of monetary policy is a key in ensuring that contagion from financial markets to the real economy does not occur.

On what we’ve witnessed to date, we would have to judge Chair Powell’s communication skills as poor. In fact, the equity rout can be traced back to October, with Chair Powell’s inopportune characterisation of the US fed funds rate as being a long way below its neutral rate. The Fed’s communication efforts following their FOMC December meeting this week were little better. The Fed lost an opportunity to calm market fears by a greater recognition of the risks volatile financial markets pose to the global economy.

While President Trump’s remarks over recent days made it virtually impossible for the Fed not to raise rates, the FOMC should have at least acknowledged the possibility of slowing (or even halting) the pace of balance sheet reduction; i.e., the pace at which they are reducing the holding of US Treasuries as they unwind the balance sheet impact of quantitative easing.

Instead, in answer to direct question on the pace of balance sheet normalisation during the press conference following the FOMC meeting, Chair Powell offered a dogmatic response that they would continue to approach the reduction in the Fed’s balance sheet as being “…on automatic pilot.” Not surprisingly, the S&P 500 took another tumble falling by 1.6%, taking the decline over December to 10%.

Fortunately, Chair Powell and the Fed have a lengthy break from having to set monetary policy, with the next FOMC meeting not scheduled until 31 January/1 February. This gives them time to work on their communication and approach to monetary policy so that the current spike in risk premia is halted, market volatility abated and financial markets are not allowed to undermine what is otherwise a healthy economy.

Table 1: Financial market movements, 13 – 20 December 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,467.4

-6.9%

US

2.81%

-10.7 bps

US Dollar Index (DXY)

96.28

-0.8%

Nikkei 225

20,392.6

-6.5%

Japan

0.03%

-3.0 bps

USD-JPY

111.72

-1.5%

FTSE 100

6,711.9

-2.4%

UK

1.27%

-2.3 bps

GBP-USD

1.270

0.3%

DAX

10,611.1

-2.9%

Germany

0.23%

-5.7 bps

EUR-USD

1.148

0.9%

S&P/ASX 200

5,505.8

-2.8%

Australia

2.34%

-12.4 bps

AUD-USD

0.714

-1.2%

Source: Bloomberg

 

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