There's not much the Fed can do to soothe crabby markets

The holiday cheer has been constrained by significant market strains of late. The S&P 500 index is down 15 percent from its September peak with more than half of its components in a bear market (down more than 20 percent). This route has sparked fears that the U.S. economy is headed for a recession.

However, while it appears the Grinch is about to steal Christmas, we should remind ourselves that there is a lot of white space between the current “green” of a 3-percent economy and the frightening “red” of a recession.

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The Federal Reserve has a key role to play in ensuring a white Christmas. Indeed, while several factors have weighed on market sentiment lately, including political uncertainty, global growth concerns and trade tensions, the one common denominator appears to be the Fed’s outlook for monetary policy. How will the Fed act in 2019 as it attempts a soft landing of the economy?

The Federal Open Market Committee’s (FOMC) policy statement Wednesday and accompanying economic projections along with Chairman Jerome Powell’s press conference contained some answers, but the “dovish hike” still left markets downbeat heading into the new year.

In its FOMC statement, the Fed announced a widely anticipated, 25-basis-point increase in the federal funds rate while simultaneously changing the language to adopt a more dovish tone.

The Fed now “judges that some further gradual” rate hikes will be necessary in the near future, thereby signaling more cautious monetary policy tightening in 2019. The underlying caution was further emphasized by adding that policymakers would “monitor global economic and financial developments” in light of the recent market turbulence and global growth slowdown.

This signal was further reinforced by the infamous “dot-plot” highlighting a downward shift in FOMC participants’ median estimates of the federal funds rate at the end 2019 and 2020. The Fed’s median dot plot estimate now foresees only two rate hikes in 2019 — down from three previously — and one rate hike in 2020.

Further, policymakers revised down their estimate of the long-run neutral federal funds rate indicating less cumulative policy tightening in the coming months.

Policymakers appear to have walked back their desire for a “restrictive” (i.e. one that would constrain economic activity) monetary policy stance in 2020 by lowering their estimate of the federal funds rate to 2.8 percent, in line with their estimate of the long-run neutral rate.

Economic projections were also revised lower with GDP growth seen at 2.3 percent year-over-year in the fourth quarter of 2019, down from 2.5 percent in their September projections and the core personal consumption expenditure index — the Fed's preferred measure of inflation — foreseen at 2.0 percent at the end of next year, from 2.1 percent previously.

The outlook for the unemployment rate was revised higher in 2020 and 2021 while their estimate of the natural rate of unemployment was revised lower, implying less risk of an overheating economy and thus less need to tighten monetary policy ahead.

Finally, Chair Powell’s press conference reinforced the Fed’s dovish pivot ahead of 2019. Stating “emerging cross currents” and several risks to the outlook, Powell defended a data-dependent and cautious approach.

He reiterated multiple times that Fed policy was now at the bottom range of “neutral” policy, and that future Fed decisions would take into consideration the recent tightening of financial conditions, trade tensions and global growth slowdown.

The trouble is that markets seem more irritable these days, and seemingly minor communication blunders can cause disproportionate reactions.

During the press conference, Chair Powell responded to a question about the future of balance sheet normalization by saying that it was proceeding smoothly, and that he didn’t foresee the need to change that. Markets took exception to the statement, assuming the Fed wouldn’t adjust its plans even if liquidity conditions were to dry up.

While this is clearly not what Fed Chair Powell meant, this was enough to push stocks down 1.5 percent on the day and yield on 10-year Treasuries down below 2.80 percent.

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Interestingly, this press conference was likely only a warm-up ahead of the contortionism act the Fed will need to perform at the eight FOMC press conferences in 2019. Indeed, the late-2018 paradox of an economy growing at 3 percent and markets behaving as though we were in a recession could worsen in 2019 as the U.S. and global economy slow in tandem.

The question is then what can the Fed do to assuage markets? Truth be told, there may not be an optimal take as it seems markets are in a predisposed sour mood. If the Fed activates its “Powell put” by signaling no further rate hikes, then markets will likely panic and assume things will get much worse from here.

If instead the Fed announces a balanced message of ongoing policy normalization amid a strong but slowing economy, then markets will react by negatively too. As such it seems there is no “winning” in this tantrum.

Now that neutral monetary policy is within reach, Fed Chair Powell and the FOMC appear decided to proceed as if they were Santa Claus in “dark room full of furniture." Proceed slowly and with great care, while hoping that the Grinch doesn’t trip them up and wake up the kids!

Gregory Daco is the chief U.S. economist at Oxford Economics.