Patience And Pause: Fed Holds Rates Steady, Dials Back Hawkish Language

Fed officials recently began talking about a “pause” for interest rates. Wednesday’s decision to keep rates unchanged and to remove some hawkish language from its previous statement might indicate the “pause” is underway.

It wasn’t just the decision to keep rates unchanged. It’s also some language missing from the statement. The words, “further gradual increases” in rates, which appeared to spark fear when they appeared in Fed’s language last month, were conspicuously absent this time.

In addition, a word that’s popped up a lot lately in Fed speeches appeared in the statement as well: “Patient.” Overall, the statement looked dovish.

“In light of global economic and financial developments and muted inflation pressures, the Committee will be patient,” the statement read. The phrase, “muted inflation pressures” was another new addition not seen in the previous Fed statement, and also sounded less hawkish.

The Fed also issued a special statement on its balance sheet, which has come into focus over the last week as some economists debate whether the Fed’s unwinding of this portfolio of bonds and other assets might be slowing the economy by pushing up borrowing costs. The jury is still out on that, but the Fed appeared to try to ease concerns, saying it’s “prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.”

The Fed, which has been letting $50 billion per month of securities run off its balance sheet, also said it would have an “ample” supply of bank reserves. That could indicate it still plans to have a large balance sheet even when it’s finished pruning it. Last month, Fed Chairman Jerome Powell seemed to spook some investors when he spoke about a “substantially smaller” balance sheet.

A “Solid,” Not “Strong” Economy

The central bank called U.S. economic activity, “solid,” a change from “strong” in the December statement. That might speak to the Fed detecting signs of slowing in the economy. It noted that its inflation gauges “have moved lower in recent months.”

How do you define “solid” vs. “strong?” One thought is that solid means more consistent, but strong means, “we’re really rolling along.” If strong is equivalent to a “five-star” rating, maybe solid is four stars.

The Fed did keep language from last time saying that the labor market “continues to strengthen” and that “job gains have been strong, on average.” Household spending, it said, “has continued to grow strongly.” None of this has changed from the December statement, and all of it would appear to support contentions that the U.S. economy is still in good shape.

Today’s rate decision probably wasn’t much of a surprise to most investors, considering the futures market had pegged chances of a hike at just 1% going into the meeting. Fed Chair Powell and other Fed officials telegraphed pretty convincingly over the last month that a pause might be in order, and not just for this one meeting, either.

Investors who got used to the Fed raising rates every quarter in 2018 might have to adjust to a little less excitement. Some analysts are comparing this to the “pause” of 2016, when the Fed waited an entire year to raise rates after doing so in December 2015. It was seen at the time as sort of a test of how the economy would react to a slight tightening after years of rates being essentially zero.

Rates are much higher now than they were then, and there was widespread concern in December when the Fed upped the target range for its benchmark funds rate to the current 2.25% to 2.5%. At that time, a lot of economists had warned the Fed that it might want to consider leaving things alone considering slowing economies overseas and signs of U.S. growth easing. Those economists didn’t convince Powell and company, who voted unanimously for the hike. In the press conference following that meeting, Powell appeared to spook at least some investors when he talked about the balance sheet reduction program being “on autopilot.” Investors read that as an indication of further tightening, and the market tanked.

That’s quite a different reaction from the market’s response to today’s Fed statement. The S&P 500 Index (SPX) recently was up 43 points, or 1.6%, for the session. A lot of the gains came earlier based on strong earnings from Apple Inc. AAPL and Boeing Co BA, but the Fed news appeared to spur some additional buying vigor.

The Two Ps: Pause and Patience

After the December Fed meeting, the central bank’s language started to change toward a more dovish tone. Most Fed speakers over the last month seem to be reading from the same hymnal, and the operative words arguably have been “pause” and “patience.” Those were some of the takeaways from speeches earlier in January by Federal Reserve Bank of Dallas President Robert Kaplan and Kansas City Fed President Esther George. According to Kaplan, it would be “wise to be patient” for the Fed, he told reporters. He said the Fed should be thinking in terms of “months, not weeks.”

George, meanwhile, said, “A pause in the normalization process would give us time to assess.” That might have seemed like a bit of a surprise coming from George, who some analysts describe as typically rather hawkish. Powell himself said the Fed will be “patient.”

After the Fed announcement today, futures prices indicated chances for another hike at 1% for the March meeting, and less than 10% for the June meeting. The market pegs odds of rates rising before the end of 2019 at just around 15%. That’s quite a change from where things were a few months ago, when many investors appeared to expect two rate hikes this year.

In his press conference immediately after the decision, Powell said the case for raising rates has “weakened.” He added that monetary policy is “appropriate” and in the range of the Federal Open Market Committee’s (FOMC) estimates of neutral. That would mean rates at a level that neither would spark additional economic activity nor suppress growth.

Asked at the press conference if the Fed might quickly change course if it started to see inflation flare up, Powell said there’s “no need for a rush to judgment,” though he emphasized the Fed, as always, would pay close attention to inflation as well as other data. This might help soothe investors going into Friday’s payrolls report, as recent data have shown a strong rise in hourly wages.

How long is the Fed prepared to be patient? Powell was asked this at the press conference but declined to mention a timeframe. “The length of this patient period will depend entirely on incoming data...so it’s hard to label it,” Powell said.

A Delicate Balance

Just last week, The Wall Street Journal reported that the Fed officials are closer to ending the central bank’s bond portfolio wind-down. If the Fed stops shrinking its $4 trillion portfolio of bonds and other assets, that could be another path toward keeping borrowing costs low and providing economic stimulus. The question is whether that’s needed, as U.S. consumers seem healthy and earnings continue to grow, though that growth is expected to slow quite a bit this year compared with 2018.

The rest of the world’s economy, however, isn’t doing as well (see more below), which could put the Fed in a tough position. It wouldn’t want to do anything to slow the U.S. economy if it’s already being dragged by overseas weakness, but if it’s too loose in its policy, a strong U.S. economy could conceivably start to feel the heat of inflation. Wages rose 3.2% in December from a year earlier, and unemployment remains below 4%.

The Fed’s recent more dovish vibe seemed to calm down the market a bit after the interest rate scare last fall when the 10-year Treasury yield jumped above 3.2%. It’s now trading around 2.7%. With worries about Fed tightening perhaps less of a factor, market volatility has eased over the last few weeks. The VIX—the market’s most influential “fear indicator”—traded under 19 early Wednesday after topping 30 a month ago.

FIGURE 1: SEAS OF RED AND GREEN. After bottoming out in late December, the S&P 500 Index (SPX - candlestick) began its march higher through the January Fed meeting. Meanwhile, the yield on 10-year Treasury notes (TNX - purple line) bounced in early January and leveled off near 2.7%. Data sources: S&P Dow Jones Indices, Cboe Global Markets. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.  

Uncertainty Drives Gold, Also Underpins Dollar: Common wisdom around markets is that gold and dollar often have an inverse relationship. When one rises, the other tends to fall. Well, gold has been on a tear since last September, but the dollar shows no signs of packing it in. This could reflect all the geopolitical balls in the air that appear to be driving some investors toward what they might see as “safer” investments, though no investment is ever truly safe. There’s Brexit, U.S./China trade negotiations, a deadline in mid-February for another potential U.S. government shutdown, and turmoil in oil-producing Venezuela. Typically, uncertainty tends to support gold prices. Since the end of September, gold is up about 10%, reaching $1,310 an ounce early Wednesday compared with below $1,200 back then.  

Over that same period, the U.S. Dollar Index ($DXY) is essentially unchanged, still trading between 95 and 96. Brexit’s potential impact on the pound might be a factor supporting the dollar despite gold market strength. One thing to consider watching, however, is central bank policy. The Fed and other major central banks are sounding more dovish, so we’ll have to wait and see if that starts to weigh more on the dollar, as looser monetary policy sometimes does.

Fed Lacks 20/20 Vision This Time: The Fed came to its decision today lacking information it normally would have. That’s because the government shutdown, which ended last week, prevented release of some key data. These include Gross Domestic Product (GDP) and December personal income and outlays,  as well as a December trade report. The Fed typically keeps a close eye on these numbers, so in effect, it was flying slightly blind this time out. 

When Q1 GDP ultimately comes out this spring, it might be interesting to see if it reflects any impact from the shutdown. The Congressional Budget Office (CBO) said this week that the shutdown cost the economy $11 billion, including a permanent $3 billion loss. The CBO also projected economic growth will slow this year to 2.3%, compared with 3.1%  last year, as benefits of the new tax law begin to fade. 

A Look Across the Pond: As investors ponder the next possible move by the Fed, some might look to Europe for some additional insight. Earlier this month the rate on the German 10-yr Bund sank to its lowest level in nearly two years, and as of today sits at a mere 0.188%. Recall that the German benchmark interest rate spent a chunk of 2016 on the negative side.

Though the European Central Bank (ECB) recently announced a phase-out of its $2.9 trillion bond-buying program, this week ECB President Mario Draghi said the central bank “stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards the governing council’s inflation aim.” With the latest eurozone inflation reading clocking in at a less-than-robust 1.6%, and with the ECB having just pushed its next expected rate hike out to mid-2020 (from late 2019), it seems the “pause-and-patience” approach is occurring on both sides of the Atlantic.

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