The Fed Doubles Down on Message of Patience
Most investors were expecting an uneventful meeting for the US Federal Reserve (Fed) on March 20. However, the central bank’s statements were even more dovish than expected. The Fed stressed its positive view on the U.S. economy, but sent clear signals of caution on weaker economic data and increasing risks. Economic forecasts for 2019 and 2020 were revised downward. A 2019 rate hike is, for the time being, off the table. All else equal, this is good news for investors.
What does a dovish Fed mean for markets?
The Fed’s stance is important for several reasons. Stable interest rate expectations help businesses to set clear investment plans. Consumers, too, can consider home or car purchases without worrying as much about an uptick in interest rates. Stability – particularly at a relatively low level of real rates – can be a powerful force for an economic turnaround.
A dovish Fed also plays a significant role in setting financial market expectations. Mixed economic data has contributed to recent market volatility. Stable expectations for interest rates, mixed with a good environment for companies and consumers, are a positive for US equity markets, as well as for global economic growth.
There is one caveat to this generally positive view of today’s Fed move: the markets are currently pricing interest rates at 60bps below the Fed’s 2019 year-end expectation. With the Fed even more supportive than most economists expected, this could indicate room for disappointment later.
According to the Fed’s current projections, it will not raise interest rates in 2019, but will continue to purchase fewer securities (engage in “quantitative tightening”) throughout the year. A second, and substantial change that the Fed could make is to its inflation target.
The idea works like this: the Fed currently has an inflation target of 2.0%. However, over the past several years, core inflation has been below 2.0% more often than it has been above 2.0%. As a result, long inflection expectations have become anchored in a lower number. That’s important for policymakers because it means they can’t raise interest rates as much when times are good, and leaves them with less firepower to boost the economy during a recession.
If the Fed is always paddling upstream to get to its inflation target, then it won’t be as effective. If the Fed can increase its inflation target – whether by increasing the number or by changing the way that target is signaled – then it could give the Fed more room to manage the economy’s ebbs and flows, improving market outcomes in the long term. The Fed will discuss its options in June, and markets will certainly be watching.
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