The Federal Reserve Open Market Committee on Wednesday signaled that it in all likelihood has ended its policy normalization campaign. The FOMC is attempting to engineer a soft landing for an economy that rapidly decelerated during the first quarter of 2019 amid global economic headwinds, volatility across asset space, and policy risks associated with U.S. trade policy.
Moreover, the clarification by the Fed on the timing of its cessation of balance sheet reductions and the likely size of its balance sheet clearly implies the limited traditional range of options at the central bank’s disposal, on top of the inadequate firepower via rates when the business cycle ends. The Fed opened its kimono in a rare way this afternoon as it tacitly acknowledged the growing risks around the economic outlook and the set the predicate for what is to come after the end of the business cycle.
The committee chose to hold its policy rate in a range between 2.25 and 2.50 percent. The Fed dot plots (below) imply that the central bank will not lift its policy rate in 2019; in our estimation, there is a greater probability of a Fed rate cut than there is a rate hike. In all probability, this is a good as it gets for the central bank during this business cycle. From here on in, it going to be all heavy lifting as the central bank seeks to mitigate non-constructive trade policy from the current administration and carefully calibrates the growing headwinds from the international economy as it seeks to provide a cushion for the domestic economy.
The Fed also revised down its 2019 real GDP forecast to 2.1 percent from 2.3 percent and its 2020 forecast to 1.9 percent from 2 percent. The central bank also revised up its estimate of the unemployment rate in 2019 to 3.7 percent from 3.5 percent and expects an increase in the unemployment rate in 2020 and 2021 with the long run central tendency standing at 4.3 percent. The estimate of inflation was revised down to 1.8 percent for 2019 from 1.9 percent and remains unchanged and on target at 2 percent over the next two years.
Just as important as the federal funds rate and the dot plots was the slowing of the balance sheet reduction to $35 billion per month from $50 billion per month starting in May with the balance sheet reduction effort terminated in September, 2019. Our calculations imply that each additional $20 billion in balance sheet reduction is equal to about a 5 basis-point increase in financial tightening.
The Fed is no longer truly concerned, if ever it truly was, about an overheating economy. With inflation risks off the table in the near term, the Fed will begin to turn its attention to using open mouth operations to support financial markets, as investors attempt to ascertain if the current slowdown is a growth head fake or a harbinger of things to come.
