Every Word Counts, Especially If Your Name Is Jay Powell
Volatility has increased since Powell’s October interview in which he said that interest rates are “a long way” from neutral. The 10-year Treasury rate increased from approximately 3.05% to around 3.25% before fully reversing course by late November as the equity market declined amidst global economic concerns. Interest rates started declining further on November 28th as Powell commented on interest rates saying, “they remain just below the broad range of estimates of the level that would be neutral for the economy.” The corresponding confusion has resulted in increased uncertainty in both the bond and equity markets. The recent market volatility and interest rate confusion is what makes this week’s Fed meeting especially interesting.
Investors will receive three key pieces of information from this week’s Fed meeting: the regular decision to raise or not raise the Federal Funds rates, the release of the quarterly ‘dot plot,’ and comments on the economic outlook in the news conference on Wednesday. Combined, these pieces of information will hopefully help investors to understand better the Fed’s thoughts on interest rates as we head into 2019.
The market generally expects the Fed to raise the Federal Funds rate by another 0.25%, so a rate increase, which we also expect, should not be major news. The updated ‘dot plot,’ which provides each FOMC’s participant’s estimate of the appropriate Fed Funds rate for the next three years, as well as a longer run estimate, will likely be a bigger piece of news. Currently, the Fed Funds rate is at 2%-2.25% and the September 2018 dot plot assumed one more increase for 2018 and three more increases in 2019. Many investors think this may have changed as the Fed appears to be focusing more on recent, more uneven data than any sort of pre-determined path. The press conference will provide a forum for Powell to shape the narrative regarding the drivers of policy. Regardless of the ‘dot plot,’ economic data will ultimately determine the Fed’s actions in 2019, so focusing on the data is likely more productive over the long term.
The Federal Reserve Act specifically directs the Fed to focus on its dual mandate of maximum employment and moderate inflation (stable prices). By both measures, the Fed is doing a pretty good job. Employment is extremely strong by almost all measures. Unemployment is extremely low at 3.7% and is expected to decline further to 3.5% in 2019. Job openings are simultaneously near all-time highs at over 7 million, so employers are still looking to hire, which could put upward pressure on wages. Correspondingly, nominal wages are rising at post-recession highs of over 3% in October and November. The other part of the mandate, inflation, has been trending upwards slowly in 2018 and is now close to the Fed’s 2% target. Furthermore, Inflation could potentially pick up due to growing wage pressure given the extremely tight labor market.
With the employment outlook so strong and inflation close to the Fed’s target (and potentially rising), additional interest rate increases seem likely in 2019. Some investors think the economy is headed into a recession in the near future, so they favor keeping rates unchanged. Many of these are the same people who have been forecasting recession for years and they will surely keep at it until it happens. Obviously, much will depend upon the economic outlook remaining relatively healthy, which is what we currently expect in the near-term. Investors should acknowledge growth will likely be at a slower rate in 2019 than 2018, since 2018 was stimulated by the tax package passed at the end of 2017.
The Fed will likely signal more rate increases to come, but will do so with the caveat that it will be cognizant of any changes in the economic outlook. Investors will be listening carefully to Jay Powell’s choice of words—and the order in which he delivers his messages. If he emphasizes risks of rising inflation more than the risks to growth, interest rate expectations will likely ratchet higher—causing bond prices to fall. Management of fixed income investments has required vigilance on both credit and duration dimensions all year, and never more so as we head into 2019.
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