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Economic Insights

The U.S. Federal Reserve tightened by 25 basis points on December 19, but dialed back its rate-hike projections—and economic growth forecast—for 2019.

(Originally published on December 19; updated  on December 20 to include additional analysis in final paragraph.)

The Federal Open Market Committee (FOMC), the policy-making unit of the U.S. Federal Reserve (Fed), raised interest rates by 25 basis points at the conclusion of its two-day meeting on December 19, the ninth rate increase since December 2015 and the fourth this year. The FOMC’s move, which upped the mid-point of the fed funds target range by 25 basis points, to 2.375%, was widely expected.

In a set of projections released at the end of the meeting, Fed policymakers’ “dot plot” indicated that they envision two more hikes in 2019, down from expectation of three in September. However, this should not be viewed as the likely number of increases or an estimate by the FOMC. It is entirely dependent on the forecast being realized and is only an expectation in that conditional sense.

The Fed’s projections for gross domestic product (GDP) growth and inflation for 2019 were both lowered modestly. The inflation rate in 2019 is now expected to remain below the 2% target. At his post-meeting press conference, Fed chair Jerome Powell noted that tighter financial conditions are the reason that GDP growth forecasts and the “dot plot” were revised down.

The Fed now believes it has reached the lower end of the range in which the neutral rate lies (the neutral rate is the rate at which the Fed is meeting its dual mandate of maximum employment consistent with 2% inflation). Previously, the Fed had indicated that the neutral rate was thought to be in the 2.5%-3.5% range, so this is a modest easing.

Having reached the lower bound of the neutral range, the Fed believes that it can move more deliberately with respect to future rate increases. The FOMC does not expect to tighten every quarter in 2019 as it did in 2018, because growth is expected to slow and inflation is expected to remain below target.

Wage gains are accelerating gradually and that is a “welcome development,” Powell said. Gradual wage gains are not necessarily going to cause higher inflation.

The contraction of the Fed’s balance sheet is on “autopilot” and independent of interest rate increases, Powell said. After 2013, the Fed decided to use interest rates for countercyclical monetary policy and set balance sheet policy independently. Powell sees no current signs of strain arising from the balance sheet.

The Fed chair firmly rejected the notion that political pressure—including recent tweets from President Donald Trump—plays any role in FOMC decision-making. The Fed has extensive contacts that it relies on instead. Powell added that the Fed only factors in financial market conditions to the extent that their movements and volatility affect financial conditions.

Anecdotal information from businesses reflects increasing “angst” about future growth arising from a wide variety of potential influences. But Powell doesn’t see that much weakness yet apart from the modest economic softening the Fed expects; a sharper slowdown may, or may not, come to pass.

Although the markets indicated their displeasure with the Fed’s policy path, with major U.S. equity indexes moving sharply lower and U.S. Treasury yields falling on December 19, we believe the key takeaways from the FOMC statement and Powell’s subsequent remarks are positive. In addition to its adjusted stance on the neutral rate, the Fed maintained its sanguine view on inflation, with Powell indicated that he believed continued wage growth would not spark a sharp rise in prices. These developments could be seen as positive for asset markets in the coming year as investors grasp the implications of Fed’s moderately more dovish stance.

One Further Thought

One of the reasons why we believe the Fed will continue raising rates as long as the economy keeps growing above the estimated 1.75% trend of potential output—even if inflation remains low—is to put as much distance between the current rate and the zero bound as possible before the next recession begins. The Fed has cut rates by 500 basis points, on average, during past downturns. At the moment, it cannot even cut them by half as much. With fiscal policy constrained by an already bloated budget deficit, in our view, the Fed is acting prudently by raising rates to create as much room for stimulus as it can to provide support when the economy weakens; monetary policy will have to carry a heavier countercyclical load than usual in the next downturn. As long as the Fed isn’t risking setting off that weakness by tightening too much, it is acting prudently in raising rates now. While Powell did not cite this motivation for continuing to tighten in the press conference after the December 19 FOMC meeting, in our opinion, it is a key part of the Fed’s medium-term strategy.

To hear more from Giulio Martini and other Lord Abbett investment experts, register for our 2019 Market Outlook webinar on January 2 (for financial professionals only).

 

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