For the past two years, the Federal Reserve has embarked on a gradual and fairly predictable path of weaning the markets off a 10-year policy of easy money. The Fed gradually halted its bond purchases and raised rates in an orderly fashion every quarter. The Federal funds rate was increased 25 basis points in 2017 and three times this year.
Most analysts expect the Fed will raise rates once more this year. However, the outlook for 2019 is anything but certain. There are a number of external economic factors that are currently weighing on the central bank's decision to remain at the neutral setting — the designated rate at which the economy neither accelerates too quickly or abruptly slows.
Federal Reserve Chairman Jerome Powell, an attorney, is not a doctrinaire econometrician and is leery of relying too much on economic data that is revised frequently and, at times, can be slow to indicate longer-term trends in the economy. Powell has made it known that he favors a more practical, rather than a strictly academic, approach to monetary policy.
One of the sacred cows of Federal Reserve economic forecasting, which, in part, forms the basis for its interest rate fine-tuning of the economy, is the idea, accepted for decades as almost sacrosanct, that low unemployment and inflation always occur in tandem. Powell has stated that in the 21st century economy, that correlation may not always hold. The willingness to deviate from decades-old economic modelling theory has injected a measure of uncertainty and has put some investors on edge, as it adds additional unpredictability on the direction of the yield curve and predicting overall Fed response to expectations for inflation.
Powell’s inclination now seems correct. Unemployment has reached its lowest level since 1969, while the economy has continued its unbroken growth rate of 3%. Inflation has remained relatively low throughout this period. These historically unusual current indexes of economic activity present unique challenges for the Fed. Powell has made it clear that assisting investors in the stock market in terms of their ability to forecast rates is no longer a priority of the Fed — especially after a decade of quantitative easing that blessed investors with stable markets.
What all this means for investors is that they will be more hard-pressed than usual in determining when to shift or reallocate assets appropriately in response to changes in the yield curve. For example, after some Fed officials indicated the neutral rate should be in the 2.75% to 3% range, investors interpreted this consensus to mean the central bank's policy committee had reached a consensus on the upper and lower ranges for neutral.
Powell seemed to disabuse investors who relied on these indications when he stated last month at a discussion in Washington that rates are “a long way from neutral at this point, probably.”
Many investors took Powell’s comments to mean the Fed had a stronger inclination for raising interest rates rather than in maintaining the current federal funds rate. The comments contributed to a selloff in the bond markets, causing higher yields that created volatility in the stock market.
Another unorthodox factor that will make predicting rates less certain is the Fed’s flexibility in stated belief that it needs to monitor economic factors on a regular basis so as to have sufficient information as a basis for establishing a neutral rate. Although the increased rate frequency may provide the Fed with a tool to fine-tune the economy with more precision, it complicates matters for investors in terms of responding in a timely manner to shifts in short-term interest rates for purposes of making the appropriate asset changes in their portfolios.
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