Source: (T) Bloomberg. (L) Macrobond. (R) FS Investments. The Beige Book Sentiment Indicator represents the number of times “strong” and variants are mentioned less the number of times “weak” and variants are mentioned in the Fed Beige Book.
We expect the Fed to hold rates steady in 2019, leaving this rate hike cycle stalled – if not stopped completely – at historically low levels of 2.25%–2.50%. This static rate outlook does not mean the Fed will disappear from headlines, however. Yield curve inversion means markets are now more seriously considering a Fed rate cut. Add balance sheet changes and the reconsideration of the Fed’s inflation framework, and Fed-driven volatility could remain at the fore in 2019.
While the Fed funds forecast of no rate change may look static, market expectations of what Fed policy will look like in 2019 have been anything but. As recently as November of last year, the Fed was expected to raise rates over 80 bps – over three rate hikes – in 2019. Weak data and volatile financial markets quickly caused the Fed to pivot to patience, in large part because consistent core inflation readings below 2% negate the urgency to push rates beyond neutral.
However, talk of a Fed rate cut is likely premature. The Fed’s economic projections already forecast the economy to slow from its 2018 pace. Historically, when the Fed cuts rates, it is typically part of a significant policy response to a recession. Should a recession materialize, the Fed rate outlook would undergo a seismic shift, not a single rate cut.
Other Fed policies will bear close watching. The Fed is expected to shift its current policy of slowly shrinking its $4.2 trillion balance sheet. Separately, the Fed is undertaking a broad review of its inflation framework as it faces years of inflation below 2% and arguably falling inflation expectations. We do not expect either of these issues to meaningfully alter Fed policy in Q2, but the chance for a communication misstep remains significant. The fourth quarter of last year was an important reminder that Fed rhetoric can inject significant volatility into markets.
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