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Investment outlook

The Fed sees “solid” growth but not higher rates

Brian Nick
Chief Investment Strategist, Nuveen
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Key points
  • Things have been looking up for the U.S. economy since the Federal Open Market Committee (FOMC) last met in March and announced it no longer planned to raise interest rates in 2019.

  • Signs that core inflation has cooled should make policymakers comfortable with that decision and allow for patience as they await clear signs of what the next move should be.


What happened?

The Federal Reserve (Fed) announced no changes to interest rate policy at its April-May meeting and made relatively few alterations to its post-meeting statement. Notably, it used the past tense when referring to slower household spending and business fixed investment, perhaps an acknowledgement that momentum seemed to improve in March. While recession risk appears lower than it did earlier in the year, inflation has also remained stubbornly low, allowing for continued patience on interest rate policy.

In his now-regular post-meeting press conference, Chair Jerome Powell appeared less concerned that inflation would remain low for long enough to prompt an eventual rate cut. Powell theorized that  transitory factors may be contributing to the current below-target level of inflation. This seems to support the view that the Fed is satisfied to keep the federal funds target range at 2.25% to 2.50% with no clear bias toward either a cut or a hike as it next move.

Markets reverse after the meeting

Markets remain sensitive to the risk that the Fed will eventually commit a policy error by over-tightening monetary policy and inviting recession. While that risk appears less serious today than it did at the start of 2019, interest rates rose sharply as Chair Powell appeared to downplay the risk of persistently low inflation in his press conference. Treasury yields and the U.S. dollar had initially declined following the statement’s release, but those moves fully reversed during Powell’s opening statement. The U.S. equity market relinquished its initial gains for similar reasons.

In the wake of the Fed’s March meeting, U.S. bond and rates markets priced in a much more dovish scenario for monetary policy over the balance of 2019 and 2020. Coming into the May meeting, fed funds futures contract prices showed a nearly 70% chance of a rate cut by the end of this year. The probability declined to a still-high 56% in the hour immediately following the meeting.

This dovish outlook for Fed policy remains at odds with U.S. equity market indexes being back at all time highs and financial conditions now looser after the market panic at the end of 2018. Indeed, we know now that U.S. gross domestic product (GDP) growth was actually accelerating in the first quarter just as the Fed was pirouetting away from its formerly hawkish outlook for interest rate policy.

What will the Fed's next move be?

Investors continue to believe the Fed’s next move is more likely to be a cut than a hike. We’re not so sure. We agree that the recent changes to the Fed’s rhetoric and its policy forecasts almost certainly mean rates are staying put for now. The weakness in other developed economies like the eurozone and Japan add to the challenges the Fed would face if it turned its recent 180-degree turn on rates into a full 360-degree spin.

However, the Fed still has a dual mandate to fulfill: stable prices—which it defines as 2% core PCE inflation—and full employment, which it estimates to be 4.3%. Currently, it’s undershooting both of these targets. If unemployment begins to rise as inflation remains low, the Fed might have to cut interest rates in response. But more rate hikes could be necessary if the opposite occurs and inflation begins to accelerate given as the unemployment rate falls further.

We don’t expect the Fed to make any changes to rates in 2019, but we think there’s a better chance of a hike by December than a cut given solid economic growth and the diminishing slack in the jobs market.

Inflation has not been an issue for the market lately, but we have seen instances as recently as last year in which surprisingly high inflation data has contributed to market volatility over short periods. We would actually be encouraged to see somewhat higher inflation readings and further rate increases because of what they would signify about the strength of the U.S. economy and the pricing power of companies trying to maintain solid profits margins.

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Endnotes 
Sources 

Federal Reserve Statement, May 2019.

Bloomberg.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

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Glossary

A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.

The core PCE price index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices.

The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy and assess the risks to its long-run goals of price stability and sustainable economic growth.

 

A word on risk

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