The dovish turn at the Federal Open Market Committee’s January meeting was predicated on an interesting juxtaposition: the committee telegraphed a prudent pause in its policy normalization campaign, while not substantially revising down its forward-looking economic outlook. We expect the March meeting to rectify that internal inconsistency as the central bank brings its summary of economic projections in line with a slower pace of growth. Moreover, we anticipate that the so-called dot plot forecast of the path of interest rates will point toward no interest rate hikes this year.
Our model of the Federal Reserve’s reaction function, which we updated to include the most recent economic information, now implies that there will be no rate hikes in 2019; in fact, the Fed may need to consider a rate cut, should the clearly visible downturn in overall economic activity over the past four months not reverse course.
The FOMC’s January statement reflected the central bank’s reaction to growing global economic headwinds, turmoil in financial markets and the slowdown in the domestic economy linked to uncertainty over the direction of trade policy. The removal of “further gradual increases” in the statement and the inclusion of the phrase “patience as it determines what future adjustments” reflect a shift to a neutral policy bias; these changes will be prominently featured in this month’s statement.
Fed seen toning down view of household spending, inflation
We do expect the Fed to tone down its description of household spending and inflation. It would not be surprising to observe a shift in language around inflation expectations, as having drifted down in recent months. Most importantly, financial conditions have eased substantially over the past several months to 1.83 standard deviations above neutral on March 15 from a high of 2.24 standard deviations above neutral in September and a low of .340 in December. Given that GDP growth in the current quarter is tracking just above zero, it is difficult to see how the central bank can avoid a reduction in its 2019 growth rate to near its long term estimate of 1.9 percent. Given the weakness in current-year growth, the estimate of the Fed’s core PCE inflation estimate will decline to 1.9 percent.
The only other notable change to the statement will likely be the to describe the labor market as “solid” rather than “strong.” We expect no change in the language used to characterize inflation.
Finally, the Fed will likely use the March meeting to issue a separate plan for balance sheet normalization. We expect that the FOMC will point toward the end of balance sheet reduction by the end of 2019, which should imply a balance sheet near $3.5 trillion.