Wait and see Fed will hike rates once — at most — in 2019

Our outlook for moves by the U.S. Federal Reserve in 2019 relies on three main points.

First, the Fed struggled in 2018, with its officials making contradictory statements about their assessments of the “neutral rate" — the prevailing federal funds rate when inflation is stable and employment is full — which confused markets and spiked volatility.

Second, we expect to see clearer communications from the Fed in 2019 and believe it will adopt a data-dependent, “wait and see” approach.

Third, our base case is for no hikes to the fed funds rate in 2019 given the low inflation rate, but we realize there is a risk the Fed will hike one more time anyway.

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Communications from the Fed in 2018 were rather confusing — but not about its near-term intentions. The Fed raised interest rates at every quarterly meeting. Each time the move was almost fully priced into markets well before the event. The confusion was instead about where policy will head over the medium term.

Fed officials equivocated on how far rates were from the neutral level; they vacillated on whether restrictive policy would eventually be warranted; and they obfuscated the substance of their data-dependent approach.

Forward interest rate markets magnified these verbal gyrations: Two-years-forward overnight interest rates moved from 2.2 percent in January 2018 to a high of 3.2 percent in October before moving all the way back to 2.2 percent at the beginning of January 2019.

In his recent Jackson Hole speech, Fed Chairman Jerome Powell laid out one approach that could become the core of the Fed’s strategy. He downplayed the importance of empirical estimates of the neutral policy rate and played up the importance of data-dependence — the aforementioned “wait and see” strategy by which officials would take their cues from realized data and, in particular, realized inflation data.

Such a strategy is reminiscent of former Chairman Alan Greenspan’s monetary policy in the mid-1990s. As Powell noted, Greenspan’s strategy allowed the economic recovery to continue for a record 10 years and is considered one of the real bright spots in the history of U.S. monetary policy.

The problem is that movement toward this new strategy has not been consistent given Powell’s apparent reversion to an old strategy or simply by his lack of clarity about the Fed’s commitment to a new one. This has added to both uncertainty and market volatility.

However, the direction of the evolution of policy has been clear, and we expect a “wait and see” strategy will emerge as preferred over the alternatives, likely sooner rather than later.

This is based on four observations:

1. A moderation in U.S. economic growth will go a long way toward convincing Fed officials that monetary policy is in fact no longer accommodative.

2. Inflation continues to undershoot the Fed’s 2-percent target, even as growth has outperformed and the unemployment rate has remained below 4 percent. This calls into question the validity of its own models.

3. We see the Fed’s overarching goal as protecting and extending the economic recovery. A recession in the next year or two would be particularly challenging because it would have to grapple with the trifecta of limited room to lower interest rates, an already extended balance sheet and uncertainty about fiscal policy support.

4. Reaction to the December hike may serve as a small push toward adopting a new strategy sooner rather than later. Commentators from all sides have pointed out the weaknesses in the case for further hikes, especially given the muted inflation threat.

While the Fed has struggled to come up with a workable strategy for the next phase of the interest rate cycle, the strategies used by Powell’s predecessors have been made obsolete and will be of little use in the coming year.

As economic variables are close to target levels and accommodation has been removed, Powell must now formulate his own approach — one that’s better suited to current circumstances.

We expect it will be “wait and see,” with clearer communications and at most one rate hike in 2019.

John L. Bellows serves as portfolio manager for Western Asset Management, a subsidiary of Legg Mason. He was the acting assistant secretary for economic policy at the Treasury from November 2010 to September 2011.