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RDM BLOG - The Next Fed Meeting is Here

    “From the Desk of Michael Sheldon, CIO”

This week is a big week for the Federal Reserve Bank and the FOMC (the rate setting committee within the central bank).  The central bank should be commended for finally raising real short- term rates into positive territory (i.e. above the rate of inflation) after several years.  At its December meeting this week, the central bank is likely to raise rate by another quarter point which would leave short term rates at 2.50%.

However, what comes next in 2019 is increasingly open for debate. Given increased volatility in financial markets recently and the global economy, the central bank should probably tread carefully as it plots its outlook for the next few quarters.  In our opinion, after a quarter point rate increase this week, the Federal Reserve Bank  should signal a near-term pause and more flexible outlook heading into 2019.

In my blog, I wrote about a potential inversion of the yield curve earlier this year.  For reference, an inversion of the yield curve is when short term rates move higher than longer term rates.  Recently, this has taken place between two and five-year U.S. Treasury Yields.  While not a true inversion of the yield curve, it is probably a signal that the Fed may want to take its foot off the gas pedal at least for a short time.

For reference, a true yield curve inversion is when two-year (or three month) yields rise above 10- year treasury yields.  Historically, an inversion of the yield curve has led to a recession with a 13-22 month lead time.  However, there have been a few false signals in the past and it is worth noting that interest rates today are much lower than they have been in past cycles (partly held down by lower rates overseas).

The U.S. central bank has been able to engineer soft landings in the past.  For example, in the mid 1990’s and the late 1980’s, the Federal Reserve bank raised interest rates, avoided a recession and moved to the sidelines after a period of time.  This led to several years of additional growth in the economy and equity markets before the economy ultimately ran into trouble.

In terms of inflation, the U.S. output gap has closed (where actual output is above potential output), the U.S. economy appears to be at or around full employment and wages are finally starting to rise.  However, the U.S. core CPI inflation rate is currently running at a moderate rate of just 2.2% (on a y/y basis).  Due to the fact that oil prices have come down significantly, copper prices are down year over year, the dollar has remained strong and inflation breakeven spreads (which the central bank looks at to gauge the outlook for future inflation) have been falling,  there is not a substantial amount of inflationary pressures for the central bank to be concerned about right now.

So, what should the Fed say following its next meeting this week?

Borrowing some thoughts from the financial research firm Strategas Research, by addressing the bullet points highlighted below, the Federal Reserve Bank (at their meeting this week) may help indicate that they are closer to the end of their current three year old rate hiking cycle, which may in turn help reduce some of the stress and negative sentiment currently present in financial markets:

1) Mention that Fed officials are aware of the recent decline in housing-related activity.

2) Lower some of the Fed rate forecasts for future years to reflect fewer rate hikes.

3) Note that inflation expectations remain anchored (i.e. inflation is not a big concern).

4) Use the press conference to highlight “data dependence” going forward in 2019.

5) Have some discussion of near-term economic uncertainty caused by U.S. trade policy.

6) Note the flattening yield curve as a key economic signal.

7) Note global market uncertainty as a factor they are aware of.

We will be keeping an eye on this week’s Fed meeting for signs that they acknowledge recently market volatility has increased and that they communicate that less aggressive Fed policy may be needed as we head into 2019.

As always, we welcome any comments you may have.

Respectfully,

Michael Sheldon

 

RDM Financial Group

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