On Wednesday the Federal Reserve announced that they would not be adjusting the federal funds rate following their latest meeting. While the market initially responded to the announcement with a rally due to the prospect of stable rates being constructive for stocks, there was a tone of pessimism from the Federal Open Market Committee (FOMC) that caused the market to fade down the day’s stretch. That fade in the rally on Wednesday could also be attributed to Friday’s heavy downward movement. Wall Street reacts well to dovish surprises but not to pessimistically driven ones. While the Fed’s verbiage would imply our economy being healthy, resilient, and ready for continued market growth, the downgrades they made to their forecasts in economic growth both domestically and globally results in uncertainty in how the rate pause should be interpreted.
Just six months ago, the FOMC thought that they would soon be returning to times of on-target inflation, full employment, and interest rates that while lower than previous decades, would need to rise into growth-restricting territory to keep things on track. While the past few meetings had already signaled an adjustment to the Fed’s interest rate policies and outlook, the fact that they were still able to surprise Wall Street on Wednesday displays just how abnormal the current situation is. Their expectations for a slowdown in the economy would translate to higher unemployment than previously forecast and that they no longer expect inflation to rise above their 2 percent target. The Fed’s current forecast includes no rate hikes for the remainder of 2019.
How one responds to this data is up for speculation. The bearish outlook would see this as a sign of the economy being weaker than previously perceived and that we are closer to the end of the market cycle than expected. The more optimistic take would be that while global growth was set to slow in 2019, this outlook has been the case since the year started. In addition to this fact, the government shutdown at the beginning of the year may skew any outlook based off the first quarter towards a more pessimistic level than reality. Unemployment is still historically low and, thanks to lower energy prices, overall inflation has been kept at a more than manageable level for consumers.
However, these same factors that produce optimism also create a challenging hurdle for the Fed. The Fed’s mandate calls for a target inflation level of 2% and their preferred measurement of inflation, the core personal consumption expenditures price index (PCE), sits at 1.9%, which is obviously below the target level. The Fed has historically based much of its decisions on expectations of future inflation. When the Fed institutes a rate hike they are effectively attempting to combat an overheating economy that could result in the growth of inflation and other detrimental ailments. The response of the market to the Fed’s last rate hike in December has pushed them into considering that the neutral level for interest rates may be lower than previously anticipated, and the continued persistence of low inflation makes rates that are nominally low (nominally meaning not adjusted for inflation) higher in real terms (real meaning adjusted for inflation). The effects of this leave the Fed in a precarious spot where they have less ammunition to combat a recession in the future.
Despite the drop in the market today and the debate around the Fed’s latest decision leaving a seemingly foggy outlook, the majority consensus point of view sees no recession occurring in 2019. Neither the Fed nor most market experts see a recession occurring as likely. In fact, while the consensus doesn’t see the Fed raising rates at any point in 2019, many see a rate hike occurring in 2020. While the odds of a rate cut have risen, the fact that the consensus still points to no rate changes occurring in 2019 and potential rate hikes set for 2020 describes to us an economy that is still seen as fundamentally healthy. While the growth we saw in 2018 may have been this cycle’s peak, a more stable slower growth environment is still constructive for the market.
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