Volatility in the Market, Not in Our Monetary Policy Views

In light of recent market developments, we wanted to provide an update on our views for all of our clients.  The market seems to have substantially changed its expected pace of rate hikes over the last couple of days.  Essentially no hikes are priced in for next year, and now some are questioning the prospects of a December hike. We see this repricing as excessive and are not fundamentally changing our views on monetary policy. 

Markets Questioning Further Hikes 

U.S. equities had rallied after Powell’s remarks last week and rose further on expectations of an easing in trade tensions between China and the U.S. based on news out of last weekend’s G-20 meeting. That rosier view concerning China-U.S. relations collapsed rapidly, and U.S. equity prices have more than reversed their previous gains. There has also been a bull flattening of the yield curve. The moves resulted in the yield curve partially inverting, with the five-year falling below shorter-dated yields. Markets picked up on this as a  possible recession signal. In addition, President Kaplan gave a quite dovish interview this morning, which markets seem to have keyed in on, in which he addressed recent market moves. He focused on downside risks and emphasized that the Fed can be patient with its policy. He also referred to the yield curve inversion as suggesting economic pessimism. 

Still A Hike in December 

We haven’t changed our view that there will be a December hike. It’s hard to imagine the circumstances that would derail one at this point, especially after the minutes signaled that FOMC participants would support one. They won’t do it just because equity prices have taken a tumble. The decline to date is not nearly  substantial enough, and Powell would be loath to delay a hike and fuel the narrative of a “Powell put.” As for trade developments, just as FOMC participants likely didn’t get as excited as the market about improved prospects for an easing in tensions, they likely are not as disappointed by the turn in the other direction.  Finally, there’s the incoming data. Everything that’s come in so far is certainly consistent with a December hike, and there’s not much on the calendar that could derail it. Tomorrow’s employment report would have to be very weak, given the FOMC’s propensity to avoid reacting strongly to one release. And the claims data,  as well as today’s ADP report, suggest the employment report is extremely unlikely to be that poor. 

Sticking With a March Hike, and Expecting Another Hike Later in 2019 

We have written about how recent communications from Powell had further tilted the balance of risks toward two hikes in 2019, rather than three. In our upcoming forecast, we will assume two hikes in 2019, in March and June, rather than three. Notwithstanding Powell’s talk of data dependence, a March hike still seems likely. As was made clear in the November FOMC minutes, there is still a strong consensus that further rate hikes are appropriate, and if they don’t hike in March, it will be hard to explain why a rate hike at a subsequent meeting is appropriate, given the expected ongoing moderation in growth next year. A second hike is a closer call but would still be warranted if our forecast comes to fruition. The FOMC will take into account the worsening in financial conditions, of course, which will be seen as dampening growth. But they are also likely to mark down their dots, offsetting the tightening in financial conditions at least in part. 

Kaplan Not Representative of the Consensus In This Case 

As for Kaplan’s interview this morning, it’s important to take it with a big grain of salt. He has been on the dovish side of the FOMC recently. He was likely one of the “few participants” described in the November  FOMC minutes who, “while viewing further gradual increases in the target range of the federal funds rate as  likely to be appropriate, expressed uncertainty about the timing of such increases.” In contrast, “almost all”  participants expected a rate hike to be appropriate “fairly soon” (December). He has also previously expressed great concern about the prospect of a yield curve inversion, whereas the consensus on the FOMC is that there is not a tremendous cause for concern. And this week’s partial inversion of the curve isn’t even the full inversion that participants generally talk about as a possible signal of heightened recession risk. Kaplan would have been leaning well to the dovish side in his remarks even without recent market moves. We don’t think other FOMC participants will share their views, though recent events will only have added to concerns about downside risks. 

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