After 2018's tumultuous end—with US President Trump and Federal Reserve policymakers at each other’s throats and stock prices riding a roller coaster lower on the year—investors seem to think the Fed will hold off on any further rate hikes through the new year. At least, that's what the Fed funds futures market says.
This may be an overreaction to the market’s overreaction to the rate hikes in the latter half of 2018, which Trump adviser Stephen Moore labeled “disastrous” in an op-ed written with Alfredo Ortiz. Moore and Ortiz called for a reversal by the Fed, accusing the central bank of creating a deflation cycle. Futures markets don’t go that far, though some analysts argue that the Fed could indeed cut rates in 2019 if the economy continues to lose steam and a bear market rears its head in stocks.
What is clear as 2019 begins is that the Fed, which is still penciling in two rate hikes for next year, and markets are woefully out of sync. This may be unavoidable with a data-driven Fed looking backward and markets looking forward, but the gap seems to be widening.
Nor is it obvious that it is data which is driving the Fed. Rather, it appears to be an unwillingness to shed an optimistic view of the economy forged at the beginning of last year but which no longer corresponds to reality.
Fed chairman Jerome Powell made much of the fact in his closing press conference in December that trade tensions, government dysfunction, geopolitical issues and other things that trouble investors aren’t showing up in the central bank's macroeconomic models. As such, the Fed proceeded bullheadedly to raise interest rates again.
But what is also not showing up in their data or their models is any indication of inflation, despite a deceivingly low unemployment rate.
Global Economic Risks Skew To The Downside
Other central banks seem to be similarly out of sync. The European Central Bank (ECB) went ahead with its plan to stop buying government bonds at the end of 2018 even though two of the biggest eurozone economies, Germany and Italy, showed negative growth in the third quarter and everyone was lowering forecasts for 2019 for the area as a whole.
Again, ending asset purchases was the plan, and central bank policymakers seem to think forward guidance is chiseled in concrete despite their protestations of being able to make changes without notice depending on the data.
The Bank of England (BoE) is waiting for an opportunity to raise rates again, even though red lights are flashing and alarm bells are ringing about the probability of a hard Brexit with unforeseeable disruptions and consequences for the British economy.
Arguably, both the ECB and the BoE feel pressure to start tightening because the Fed has been doing so for more than a year.
The Bank of Japan, meanwhile, grew less optimistic about finally moving toward its 2-percent inflation target, according to summaries of its late-December meeting released at the end of the year. Falling oil prices prompted a more dovish tone in the comments, as prices seem to be moving backward toward a flat or even negative trend.
At least the Japanese monetary policymakers acknowledged that risks seemed skewed to the downside.
Quicker Action Needed As Global Economy Shifts
The big question at the beginning of 2019 is whether central bankers will wake up to the fact that they are not reacting quickly enough to shifts in the economy. It may be time to remember that they were fairly clueless about the dangers building ahead of the 2008 crisis.
Their response once that crisis broke—led by Fed chairman Ben Bernanke—may have partly redeemed them. However, the extraordinary monetary policy measures, such as quantitative easing, remain controversial and their long-term consequences unknown.
Mishandling the current transition has exposed Powell’s deficiencies as an economist. His December press conference was fairly disastrous for the markets. Aside from pinning his opinions to macroeconomic models designed by staff, he belied his own claims that the Fed is data-dependent by describing quantitative tightening as being on “autopilot.”
One of the strengths of the Federal Reserve system is that the regional bank presidents are elected by their own boards, not appointed by Washington. Each has their own large staffs of economists and researchers, and often are distinguished economists in their own right.
Historically, they remain subservient to the board of governors in Washington. They were reluctant to challenge economists as eminent as Alan Greenspan, Bernanke, or Janet Yellen, though we might have been better off had they done so more often.
These regional bank presidents each cover several states and spend a lot of time with the businessmen and politicians at a local level, giving them a feel for what is going on in the real economy that the board and its ivory-tower staff in Washington don’t have. Two of the 12 presidents, Neel Kashkari of Minneapolis and James Bullard of St. Louis, have been outspoken about the Fed pausing its tightening of monetary policy. Kashkari sees no evidence of wage-push inflation or inflation expectations coming unanchored, and Bullard thinks it is time for a paradigm shift in how we view the link between the economy and monetary policy.
Unfortunately, the Fed’s rotation of voting privileges for regional presidents—designed precisely to allow the Washington board to dominate monetary policy—means they often don’t have a vote, though they do take part in the debates at every meeting. Bullard rotates into a voting position in 2019, though Kashkari has to wait until next year. Philadelphia Fed chief Patrick Harker expressed doubts ahead of the December meeting about that rate hike, but he, too, has no vote until next year.
Dissent, even the non-voting kind, can be powerful in an institution as driven by consensus as the Fed. Perhaps the dovish voices can indeed moderate the knee-jerk hawkish tendencies of central bankers in the Federal Open Market Committee meetings.
Whatever the Fed decides to do, the other major central banks—ECB, Bank of England, Bank of Japan—will have to follow its lead, as they have done since the beginning of the financial crisis. The dollar is simply too important in world commerce and finance for them to diverge too long or too widely from the Fed policy. A longer pause in tightening would give them the cover they need to maintain accommodation for their own economies.