The nasty sell-off in equity markets has raised doubts about the Federal Reserve’s willingness to follow through with its plan to boost interest rates again in December. It shouldn’t.
The odds that market participants place on a rate hike had dropped to around 65 percent from a high of more than 80 percent a few weeks ago. The decline comes even as central bankers give little reason to doubt that another rate hike is coming. New York Federal Reserve President John Williams, a permanent voting member on the Federal Open Markets Committee, reiterated this week his expectation that the Fed would “be likely raising interest rates somewhat but it’s really in the context of a very strong economy.”
What’s going on here? The challenge for the Fed is managing an economy that is transitioning through an inflection point. The odds are very high that economic growth slows markedly next year. The lagged impact of the Fed’s seven rate hikes over the last two years (which is already evident in housing), fading fiscal stimulus and slower global growth all point in this direction. That is the Fed’s baseline forecast as well.
But will growth slow enough to ease what the Fed believes are underlying inflationary pressures? In general, central bankers believe the economy currently operates at or beyond full employment. To be sure, they are not sufficiently concerned to boost rates at a faster pace, believing instead they can use the opportunity to squeeze some extra slack from the labor market. Policy makers are, however, sufficiently concerned about the potential for overheating that they would prefer that unemployment didn’t drift much lower.
From the perspective of the Fed, that means growth needs to slow to something closer to 1.8 percent, which happens to be the Fed’s estimate of the longer-run growth rate. As of last month, the Fed forecast 2.5 percent growth for 2019, even with continued rate hikes. In other words, a slowdown to 2.5 percent leaves activity still too robust to ease the Fed’s concerns.
This, of course, creates a difficult environment for investors. If the economy is near or beyond full employment, we can expect continued pressure on profit margins even if growth slows. That is a double whammy: lower margins and slowing sales.
What does the Fed need to see to change course? In the near term, it would require a fairly dramatic change in financial conditions. Falling stocks are not enough, especially considering the concern that equity markets were overvalued earlier this year. The stress on the financial system needs to broaden. I look back to the 2015-2016 period as a reference.
Even then, financial stress was matched with softer economic data, particularly in manufacturing. That’s what would shift the Fed’s perspective. Over the medium term, such as the next six months, the Fed would increasingly shift to a more dovish stance if evidence mounts that the economy is slowing in line with the Fed’s forecasts. The more slowing seen, the more the Fed will see the time for a pause is at hand. Of course, on the other side of the coin, if the slowing is not as deep as feared, then the Fed will track in a more hawkish direction.
What should we focus on as the Fed navigates this growth transition? Two concerns jump out at me. The first is that the data lags behind the cycle and we continue to experience solid reports that keep the Fed hiking long after they should. That would be a straight up policy error, but I don’t think we are at that point. The second concern is that inflation perks up more than forecast. An unexpected acceleration of inflation could tie the Fed’s hand, especially if policy makers feared that inflation expectations would drift higher with a more hawkish stance.
Although the Fed might not ride to the rescue in the near term, the “Fed put” on the economy remains alive and well. As long as inflation remains contained, the Fed will feel comfortable shifting to a more dovish stance if data softens more than they expect.