January 31, 2020

 

Isaac Newton’s First Law of Motion states that a body at rest will tend to remain at rest unless an outside force acts on it.  While declaring policy is not on a preset course, the Fed has little reason to not follow the laws of physics and alter its wait-and-watch strategy regarding the targeted fed funds range, currently at 1.50% to 1.75%.  The U.S. economy has been supported by a firm job market, consumer spending, a rebounding housing sector and diminished risks on the Phase-1 Trade Deal with China and a Brexit breakthrough.  The economy ended 2019 on solid ground with the first estimate of the fourth quarter GDP posting a 2.1%  annualized quarterly gain.

 


GDP

 

 

However, some storm clouds from the Middle East /North Africa (MENA), China  amd even Washington D.C. have formed over the outlook since the start of the year and have largely overhsadowed economic fundamentals.  The deadly Wuhan, China coronavirus spreading in Asia and to other continents carries the potential to hurt global growth by restraining consumption and lowering travel demand and disrupting supply chains.  Along with the earlier-in-the-month spike in tensions in Iraq and Iran these external developments have roiled the markets, especially the bond and commodity markets.  The issues in MENA remain unresolved.  A persistent safe haven bid for bonds have sent yeilds lower.  Also pressuring yields to the downside are declining inflation expectations due to slump in commodity prices and the strong dollar.



Markets Inflation



In spite of the markets being in a tizzy, the Fed held the course at its January 28-29 FOMC meeting.  There appreared to be no need to raise rates due to muted inflation.  There also appeared to be no need to cut rates even if economic risks are considered tilted to the downside since monetary policy is still accommodative and financial conditions are considered easy in spite of recent event-related market volatility.  The Fed’s base case is for an extended pause, which in itself appears as a commitment to low rates and is a dovish policy guidance, removing some uncertainty in the market place.


Core Inflation


The Fed kept the targeted fed funds ranges the same, but in a “technical” move tweaked the Interest On Excess reserves Rate (IOER) up to 1.60% from 1.55%.  It was a things are not-too-hot, not-too-cold Goldilocks statement with the current stance of monetary policy appropriate.  In the Q & A session of his press conference, Fed Chairman Powell responded to a question on a very slight change on the inflation wording in the statement.  He said that was to clarify that he and other members of the Committee are not comfortable with inflation running persistently below 2%.  In addressing a question about the coronavirus spreading from China, he responded that there would be implications in the near-term for Chinese output but it was too early to speculate on the macro-economic implications for China and the potential to pose risks to global growth, but he also said there were “grounds for cautious optimism about global growth”.


Targeted Fed Funds

There have been tentative signs that employment growth has begun to slow, but it is unclear if it is being driven by a softening demand for workers or an increasing shortage of labor.  Nevertheless, in the here and now, the still-healthy jobs market has led to solid consumption and a housing market recovery.  The primary reason for the latter is rising affordability amid low mortgage rates and gains in wages.  However, the economy is running at two speeds.  The manufacturing sector and business investment are less supportive of the economy.  Moreover, there is little sign of a quick recovery in global industrial production.  The spread of the coronavirus from China and the continuing Boeing woes will have a negative impact on manufacturing output, new orders, and demand up and down the supply chains.  Additionally geo-political and political uncertainties continue to hamper plans by businesses to expand capacity.



Housing Market

 

The Fed continues to make it clear that it is resolved to hold off interest rate adjustment in the near term unless there is a material change in the outlook in the economy and inflation.  Fed policy makers are sensitive to domestic and international developments and see risks tilted to the downside, but estimating impacts on the economy and inflation would be purely speculation.  The Fed is also aware that it is still pushing a lot of liquidity into the market through expanding the balance sheet, policy settings are accommodative and low interest rates can push valuations of assets higher to the point of destabilizing the markets.  It is also historically unusual for the central bank to change course in an election year, Thus, the desire to hold rates steady and keep the bar high for policy moves, despite the current dislocations.