Fed may get less bang for the buck if it repeats 2016 rate pause


NEW YORK • For the US Federal Reserve (Fed), 2019 has started out looking a lot like 2016: The last time uncertainty over global growth roiled financial markets for months on end.

Fed chairman Jerome Powell pointed to the 2016 episode last Friday to underscore the US central bank’s ability to be flexible when necessary, recalling the Fed held interest rates steady almost all year.

But, while officials still have the option to press pause on their campaign of gradual rate hikes again, it may not have such a calming influence this time around.

At the outset of 2016, policymakers were projecting four quarter-point rate increases for the year. Sliding stock markets knocked them off track and they ended up staying on hold until making a single move in December.

Amid the turmoil, investors anticipated Fed officials would blink, which pushed down longer-term interest rates. That in turn helped offset some of the tightening of financial conditions.

In March 2016, then-Fed chair Janet Yellen referred to this effect as an “automatic stabiliser” for the US economy. It helped. The economy weathered the market turmoil and the US expansion ground on to become the second-longest on record.

Rate Forecasts
Fast-forward to now and US central bankers don’t have the luxury of relying on that automatic stabiliser.

Fed officials entered this year projecting two rate increases, but investors currently anticipate a rate cut this year has become more likely than a hike.

That leaves the Fed in a tough spot because central bankers aren’t inclined to cut rates at the moment, and the rest of the government isn’t offering any help to support investor sentiment, said Ethan Harris, co-head of global economics research at Bank of America Corp in New York. Congress has fallen back into gridlock, and President Donald Trump’s trade war with China is increasing uncertainty.

“All of the pressure is on the Fed: They are the ones that have to say the right thing to keep markets comfortable,” Harris said. “Powell talked about the baseline for the economy and downplayed the risks. That, I think, scared the markets,” he said, referring to the Fed chairman’s Dec 19 press conference, which sent stocks tumbling further.

S&P, Oil
The S&P 500 index has fallen almost 13% since September amid a more than 30% drop in oil prices. Ongoing trade tensions and a homegrown slowdown in China’s economy have combined to fan fears among investors about the outlook for global growth, just like 2016.

“With the muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves, but we’re always prepared to shift the stance of policy and to shift it significantly if necessary,” Powell said last Friday in Atlanta. “I’d actually like to point to a recent example when the committee did just that, in early 2016.”

At the end of 2015, investors had priced 60 basis points (bps) over the coming year. That fell to zero during the following six months as the Fed cut its forecast, helping offset the effect of tighter financial conditions.

This time around, prices of interest- rate swaps signal investors see rates easing by 10bps over the next 12 months, meaning the Fed would probably actually have to cut rates to offset tighter financial conditions.

That’s something they are unlikely to do unless they’re convinced a recession is right around the corner, according to Michael Hanson, chief US macro strategist at TD Securities in New York.

Powell certainly gave no such hint of a rate cut last Friday. He said economic data remained solid and pointed to the December jobs report, released earlier that day, which was strong across the board with unemployment of 3.9% still near a 50-year low.

That said, other economic indicators have softened. A monthly gauge of sentiment in the manufacturing sector, which is more forwardlooking than the employment report, plunged in December, according to data published on Jan 3 by the Institute for Supply Management. But even after the drop, the gauge remains at levels consistent with strong economic growth, as Powell pointed out.

Fed officials are unlikely to be as cautious in 2019 as they were in 2016 because interest rates are quite a bit higher now — which means they have more room to ease if they make a mistake by over-tightening than they would have had then — and because the unemployment rate is still below levels they bet are sustainable, Hanson said.

“They still believe that the danger is more to be under-reactive than over-reactive to the tight labour market,” he said. “The Fed isn’t saying it’s going to cut rates. The Fed isn’t even saying it’s going to pause.”