After its abrupt and ill-explained shift to “patience” over the past couple of months, it was always going to be hard for the Fed to deliver a dovish surprise at the March policy meeting. Somehow, they managed it.
The Fed now sees just one more rate hike by the end of 2020, compared to three previously. The two rate hikes planned for 2019 have both disappeared, leaving just one next year. It has also announced that the pace of balance sheet reduction (quantitative tightening) will slow from May and end in September.
The Fed’s recent shift from “data dependent” to “Dow dependent” was always going to cause a communication problem when the equity market bounced. It could hardly abandon its new-found “patience” just because the Dow has rallied nearly 20% from the December lows, otherwise there will be no doubt about what drives policy in Powell’s Fed. As a result, we are left with some unpersuasive changes to the Fed’s view.
There are so many parts to the Fed’s outlook that make no sense that it is hard to know where to start. Why has there been such a big swing in the policy outlook in response to a minor change in the growth forecast and no change in the inflation outlook? If you are not planning to raise rates in 2019, why would you want to hike in 2020 when you expect slower growth, higher unemployment and stable inflation? Why did the balance sheet run-off go from being on “autopilot” to nearly complete?
To be fair (?), the Fed’s view made no sense before, with stimulative policy, strong growth and low unemployment, but no acceleration of inflation. Now it just makes no sense in a different way.
It is probably more productive to focus on the implications of the policy meeting, rather than the logic behind the arguments. Two stand out.
First, the Fed plans to keep a stimulatory policy stance through to 2021, compared to the previous intention of being restrictive by 2020. It appears to be encouraging inflation to overshoot, which points to a revised framework for policy.
Second, the Fed has an asymmetric sensitivity to financial conditions, which is a nice way of saying that there is a Powell put. If markets weaken, the Fed responds; if markets rise, the Fed cheers.
We tilted our asset allocation view more positively in response to the Fed’s shift to “patience” and this still looks reasonable despite the recent rebound.
Threats to this view would be if inflation starts to move higher or if Fed credibility dives. There is clear wage inflation, but so far the pass-through to consumer prices has been muted. Moreover, even though USD slipped in response to the Fed’s policy announcement, yields on long-dated bonds fell, suggesting no fear that Fed dovishness has gone too far.
What happens next? The Fed is going to sit and do nothing for as long as it possibly can. If growth slows clearly below 2% and the unemployment rate starts to rise then the cut that is already being priced in by markets in 2020 becomes realistic. We cannot see a dynamic that would cause growth to slow so significantly, so do not view this as too likely.
Alternatively, if loose policy sustains solid growth and capacity shortages start to push inflation higher, then “patience” will need to end (remember, core inflation is already at 1.9%). This looks more likely, although timing is hard, with such sticky inflation. We have a hike pencilled in around year end. Subjectively, odds of a hike rather than a cut look about 70:30.
Disclaimer applicable to recommendation
In terms of quantitative tightening, the Fed will go from the current $50bn monthly reduction to $35bn in May and then zero in September. However, that is not the end of the story, as it will still be cutting its holdings of mortgage backed securities (MBS) by up to $20bn per month and replacing them with government securities. So the Fed will swing from adding to the supply of government debt hitting to market, to absorbing some.
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