Since the great financial crisis, markets have been intensely influenced by the words of central bankers, and that’s no different this week, as the U.S. Federal Reserve makes its next interest rate policy announcement on Wednesday. It’s widely expected that the Fed will hike rates for the ninth time since 2015, moving the target rate closer to neutral territory.
What the Fed decides to do this week isn’t the key, instead I’ll be paying close attention to the words spoken by Fed chair Jerome Powell, as the timing of future rate increases will be vitally important to the outlook for the U.S. economy as well as global stock markets. Continued hiking in the first half of 2019 to or above neutral would be a misread, and stocks would continue to struggle.
What is different at this time is that recent inflation concerns have been overblown. This should be reason enough for the Fed to adjust its policy and pause on rate hikes in early 2019 – or risk tipping the U.S. economy into recession.
If the Fed hints at a pause, then I expect the market to refocus on fundamentals and deliver positive returns in 2019. This year has been volatile with uncertainties around Brexit, Italy, emerging markets, and U.S. trade policy, among other headlines creating headwinds.
Here’s what some of the data are telling us.
U.S. economic growth for this year may come in at around 3 per cent, well ahead of the Fed’s 1.8 per cent to 2 per cent projected long-run growth rate. The fiscal stimulus agreed to by Congress late last year is having a beneficial effect and can be expected to boost growth into the first half of 2019. With that, the economy will likely post a growth rate above the long-run potential again next year. Sure, prospects for corporate profitability have weakened, but that’s relative to the very high levels achieved this year. Barring an economic shock, earnings growth should remain positive in 2019, and most signs point to a very low probability of recession before 2020.
The Fed’s “dual mandate" is to effectively achieve two goals: maximum employment and stable prices. Jobs are not an issue, with U.S. unemployment at a 50-year low of 3.7 per cent. However, inflation is contained, and the risk of it overshooting the Fed’s 2-per-cent target is low.
The Core PCE Price Index, the Fed’s key indicator of inflation, was 1.8 per cent year over year as of October, down from 2.0 per cent experienced over the summer, which had given the central bank confidence to commit to an aggressive outlook in hiking rates. Since then, consumer prices have flattened and other factors have helped hold inflation in check – wage growth is still below what it was prior to the financial crisis, productivity growth is low and a stronger U.S. dollar is disinflationary. With all that, the Fed should pause in the first half of 2019 to reassess the data and its outlook.
We are starting to see signs that this may happen as Mr. Powell has been softening his language around the determination to raise interest rates – from communicating that they may raise past the neutral rate in early October, to more recently affirming that future decisions will be more data dependent and take the impact of current events into account.
At the same time, monetary policy remains accommodative globally as rising rates have generally been limited to the U.S. and Canada. Considering the stimulus being added to the Chinese economy through lower interest rates and the easing of bank reserve requirements, policy has in fact become more accommodative outside of North America in 2018. Recently, we saw the European Central Bank come out with a very dovish tone and even the Bank of Canada is seeing room for more non-inflationary growth in the Canadian economy.
An early 2019 pause would be a clear sign from the Fed that it has not met its inflation objective and that monetary policy should remain accommodative for a little while longer – this would be supportive for stocks. A pause later in 2019 would indicate that the Fed’s confidence in the U.S. economy has not wavered, and that it believes more restrictive policy is required sooner. Mr. Jerome Powell, over to you.
Marija Majdoub is the vice-president of the Investment Management and Strategy team at MD Financial Management. She leads the team of portfolio managers and investment professionals responsible for managing the firm’s mutual funds and investment pools, and developing MD’s investment views.