Fed raises rates and sticks with its solid economic outlook: our view

Invesco Fixed Income explains what the Fed’s statement means for 2019.

Dec 21, 2018 | Noelle Corum

The US Federal Reserve (Fed) hiked interest rates by 25 basis points to a target range of 2.25% to 2.50% on Wednesday, Dec. 19, signaling it believes continued policy normalization is necessary despite a recent tightening in financial conditions (i.e. lending conditions). Below is our take on the Fed’s statement, its economic projections and Chairman Jerome Powell’s press conference.

 

  • The statement: The Federal Open Market Committee (FOMC) remained upbeat on the economy, despite its acknowledgment of tighter financial conditions and how these could dampen real economic data. It stated that risks remain well-balanced, although noted that the FOMC will monitor “global economic and financial developments and assess their implications for the outlook.” The FOMC attempted to soften its language around future rate increases, stating that the committee “judges some” further hikes are appropriate.
     
  • Summary of Economic Projections (SEP): The median dot on the FOMC’s rate hike projections (or “dot plot”) shows two expected rate hikes in 2019 (down from three previously). The dot plot lowered the trajectory of rate hikes in 2020 and beyond, with only one expected in 2020 and the longer-term rate revised down from 3.0% to 2.8%. There were also minor downgrades to 2019 gross domestic product and inflation.
     
  • Press conference: Chairman Powell highlighted the FOMC’s expectations for solid growth, declining unemployment and a healthy economy in 2019, but acknowledged many concerns that would require patience. He recognized the Fed’s growth projection is solid at 2.3%, but the 2019 growth trajectory is declining, versus a rising trajectory in 2018. He noted that inflation was subdued in 2018 and market volatility heightened. As a result, he indicated that there is a fair degree of uncertainty regarding rate hikes in 2019 and monetary policy will be less additive to growth. Powell also acknowledged that, while financial market volatility and looming uncertainties (e.g. Brexit) are difficult to model, the Fed is monitoring them closely.

Disappointed markets

Changes to the Fed’s statement, its economic projections and the tone of Powell’s press conference on Dec.19 undershot dovish market expectations, sending risk assets lower, the yield curve flatter and inflation breakeven rates tighter. Longer-term Treasury yields fell and US credit risk assets, such as investment grade and high yield bonds, reacted negatively as the FOMC pointed to continued gradual rate increases amid a moderating growth trajectory.
 

Our view for 2019

At Invesco Fixed Income, we also project moderating US growth next year. We believe growth will be supported by fiscal policy, a tight labor market and a confident consumer in the first half of 2019. However, our second half outlook is less certain as the impact of fiscal stimulus fades and monetary policy tightens. We expect two Fed rate hikes in 2019, in line with the Fed’s current projections. As the market currently expects less than one hike next year (at odds with the dot plot), we think yesterday’s Fed move will likely be perceived as hawkish unless the market adjusts to the Fed’s more solid growth outlook. Longer-term, we expect the Fed to become less bullish and lean more dovish, which would likely support risk assets. Interestingly, the US dollar failed to hold onto its recent gains, potentially indicating that Fed hawkishness perceived as a policy mistake would not be considered positive for the currency. If the market is only willing to price higher US rates if global conditions improve or inflation accelerates, it will likely limit the scope for wider real interest rate differentials, potentially removing one of the main tailwinds for the US dollar in 2018.
 


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