The continued absence of inflationary pressures provided the Fed with the scope to cut the fed funds rate for the third time in a 'mid-cycle adjustment' that has lowered the rate by 75bp, to now 1.50%-1.75%, since July.
Exhibit 1: Changes in the US federal funds rate, 2014 - 2019
Source: BNP Paribas Asset Managment, Bloomberg as of 04/11/19
There have been distinct periods since the Federal Reserve began raising rates
Phase 1 - After almost a decade of policy rates at the lower bound - a target range of 0%-0.25% - the Fed began hiking rates, by increments of 25bp in December 2015 and 2016. Then the pace was increased with three hikes in 2017, followed by four in 2018 taking the target range to 2.25%-2.50%. This normalisation of monetary policy went hand in hand with the shrinking of the central bank's balance sheet of assets acquired as part of the earlier non-conventional policy measures. In recent months, the Fed has been obliged to purchase short-term bonds to ease problems in money markets. It insists this is not quantitative easing, although its balance sheet is once more expanding.
Phase 2 - After the sharp fall in stock markets in the fourth quarter of 2018, fears arose that excessively tight monetary policy, along with a trade war, could trigger a recession. As a consequence, the Fed 'pivoted' away from raising policy rates to pausing and then, in 2019, embarked on the 'mid-cycle adjustment' - cutting its target rate three times.
Fed policy tends to move in long cycles. Mid-cycle adjustments, where the Fed pauses to cut rates for a short period, are rare. There have been two such adjustments, each totalling cuts of 75bp, since 1970.
Now officially on hold
Last week, Federal Reserve chair Jerome Powell made it clear that the 'mid-cycle adjustment' was over and that the current monetary policy environment should ensure moderate economic growth, a strong labour market and inflation close to the symmetrical target of around 2%.
The diagnosis of the US economy remains fairly positive. Consumption and employment are described as dynamic, but weakness in investment and exports was highlighted.
In line with this analysis, recent data has on the whole been positive despite disappointments, particularly with regard to industrial activity. According to the first estimate, third-quarter GDP growth was 1.9% (annualised rate), slightly above market expectations. Private consumption grew significantly (+2.9% after +4.6%), but investment continued to decline (-3.0% after -1.0%). The unemployment rate fell to 3.5% in September, its lowest for 50 years. All aspects of the employment report (net job creation, confidence in the possibility of finding a job, willingness to hire from companies) suggest a tight labour market.
Until inflationary pressures are more apparent, rate hikes are unlikely
Over the past year, wage increases have been around 3.5% year-on-year (average hourly wages of non-managerial staff assigned to production). While September inflation was 2.4% (year-on-year CPI excluding food and energy), chair Powell said that a significant acceleration in inflation would be necessary for the Fed to consider raising rates. This constitutes a major hurdle given the absence of inflationary pressures.
On both the upside and the downside, the message is clear: Unless meaningful changes occur, Federal Reserve policy should remain on hold for a significant period.
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