But the fact is that in the annals of central bank policymaking history, the capitulation this week by the U.S. Federal Reserve (Fed) WILL be remembered as one of the most memorable reversals ever.
Confusing Cyclical with Secular Signals
Let me jog your memory.
In the middle of a stimulus-driven growth spurt in the U.S. economy not too long ago (in August/September of 2018, to be precise), a whole host of Federal Open Market Committee (FOMC) members were talking gibberish: We don’t know what neutral rate R star1 is. Even if we did, we will probably exceed it in our current tightening bias, etc. etc.
At that time, them were fighting words. The bond market started taking its cue from all of that and the 10-year Treasury yield was flirting with 3.25%, on the way to 3.50%.
Of course, it was a classic case of even professional seers confusing a cyclical signal with a secular one. Once the stimulus faded, the U.S. economy was to start slowing down and growth would get closer to trend.
That is precisely how things are unfolding. The U.S. economy is slowing, not catastrophically, but slowing nevertheless. And the situation globally is even more worrisome: Europe and China have slowed even more than the U.S.
Fed Throws in the Towel
In their statement, and in Powell’s subsequent press conference, not only did they talk about patience, their guidance provided no upward bias for the Fed funds rate.
To make the surrender complete, Powell put flexibility with respect to unwinding the Fed’s balance sheet on the table. As I indicated in an earlier post, I always thought unwinding the Fed’s balance sheet was irrelevant for the direction of the market, but that the unwinding process would have to stop at some point. However, even I did not expect that to happen this quickly. It was indeed a profound and unprecedented rollback of the Fed’s policy position.
Having said all of that, I want to emphasize that it is a really wise, prudent, and entirely appropriate move by the Fed. Given that the U.S. economy is already slowing close to its trend rate of 2% and inflation is materially absent, one does not have to know what the neutral rate is to see that the policy rate is already close to neutral. Further, given how quickly the rest of the world is slowing down, the risks to U.S. economic growth were increasing to the downside. Thus, stopping on the path to further tightening, even if Fed policymakers perceive it to be temporary, is the right decision.
While there has been ample talk that the Fed decision was driven by the markets acting up in December, I believe that is confusing correlation with causality. Yes, the markets were acting up, but they were acting up because they saw a global economy slowing down at a precipitous rate in November and December 2018. One has to just look at the December real activity data in Europe and China to conclude that the slowdown was sudden and quite pronounced at the same time. In my judgement, the Fed was reacting to that far more than the markets, and rightly so.
Moderate but Manageable Global Risks
The bottom line is our core thesis for 2019 is playing out in spades. Growth is slowing on a global basis for sure, but not to a catastrophic level. Combine that with more supportive monetary policy on a global basis, and it is quite easy to see how the markets do much better than they did in 2018. The policy support from the Fed is just the beginning, in my view. Soon we will also have that from all other large central banks, in my view. Further, as the slowdown in growth starts biting, I believe the pressure to reach trade deals will increase on all sides and provide further policy support to the economy and the markets.
To be sure, there are plenty of risks still out there, as is to be expected at current market levels. Not reaching a U.S.-China trade deal, wage inflation in the U.S., German pressure on the European Central Bank to not ease, top the list. However, we believe these risks are relatively modest and manageable.
We continue to recommend investors consider buying equities, especially emerging market and international equities.
- ^R-star is defined as the real short-term interest rate expected to prevail when the economy is at full strength and inflation is stable. Source: “Just Released; Interactive R-star Charts,” Federal Reserve Bank of New York, 12/5/18.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.