The Fed took Treasury markets on a wild ride this week with the 5-year rate careening below 2.25%, levels unseen since January 2018 and inverting the yield curve out to this term. After raising rates the past three years, the FOMC signalled little inclination to do so this year and only modest leanings for next year, a seachange from the December meeting when the majority still saw three increases over this period. The Fed also plans to stop shrinking its balance sheet by October 1, at which time all maturing assets will be reinvested, and to slow the runoff of Treasury holdings from up to $30 billion currently to $15 billion starting in May and to zero by October. The futures market now sees above-even odds of a rate cut at the turn of the year, up from one-in-four before the announcement. In our view, while the tightening cycle might be over (indeed, we are seriously questioning our final rate hike in December), the odds of an outright easing are likely still limited. It would require either a weaker economy than the Fed currently expects (the median forecaster sees 2.1% growth this year on a Q4/Q4 basis), or the formal adoption of a less bygones-be-bygones approach to inflation targeting.
It’s still more likely that the Fed will extend the tightening cycle than reverse it, though perhaps not this year. While 11 of 17 members expect no rate hike in 2019, an almost similar number (10) see at least one increase next year. Only five members think the tightening cycle is over. An equal number see one rate increase by late 2021, while 7 expect two or more moves (and one lonely hawk is still eyeing five).
Importantly, none of the 17 Fed officials expect to cut rates in the next three years. In fact, an easing pivot would contradict their own view that the neutral rate (the rate consistent with price stability) is likely somewhere between 2.5% and 3.5%, with a median call of 2.75%. The current target-rate midpoint (2.38%) is already below this range, and, adjusted for inflation, is well below levels prevailing at the end of other tightening cycles. To boot, the median forecaster expects the jobless rate, though likely to tick up to 3.9% by late 2021, to stay below the so-called natural rate (the one consistent with price stability) of 4.3% (shaved a notch from December). In fact, none of the 16 officials (one member didn’t provide an estimate) thinks the natural rate is below 4.0%. Curiously, however, core PCE inflation is still expected to hold steady at 2.0% through 2021, rather than drift up as one might expect if the jobless rate stayed below the natural rate. Seems the Fed doesn’t trust Mr. Phillips.
While we don’t expect the Fed to cut rates, one clearly can’t rule out the possibility. A deeper economic slump that sends the jobless rate higher and inflation lower would easily do the trick. However, recession risks have likely ebbed now that the Fed no longer plans to push rates above neutral. More likely to trigger an easing move is that Chair Powell has become increasingly concerned about persistently undershooting the inflation target, which risks unmooring inflation expectations (though, so far, there is little sign of such in the TIPS market or consumer surveys). Who would think that a central banker would claim that low inflation is “one of the major challenges of our time” with a jobless rate near half-century lows, companies begging for workers, and the expansion soon to become the longest on record. But in his press conference, Powell said: “We are almost 10 years deep into this expansion and inflation is still not clearly meeting our target,” and followed up with “I don’t feel we have convincingly achieved our 2% mandate in a symmetrical way.” He seems to be leaning toward the “average inflation targeting” regime favoured by New York Fed President Williams. This approach would require the Fed to actively push inflation above 2% for a while to offset the decade-long stretch of undershooting and better anchor expectations on the target. However, amid a slowing economy and downward pull from structural forces, such as automation, this could require not just an end to the current tightening cycle but the start of a new easing cycle. His comments and those of other officials will be eyed closely to see if this approach is gaining credibility on the FOMC. If so, the Treasury rally, especially at the shorter end of the curve, could just be starting.