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Aon Retirement and Investment Blog

Jerome Powell’s First FOMC meeting

Summary

  • This was the first meeting by new Chair Jerome Powell.
  • There were no big surprises: the quarter of a percent hike was fully anticipated by markets – it would have been a huge shock if there was no move or a ½% hike.
  • New economic projections were, at least initially, perceived as “dovish” (i.e. suggesting that rates might go up less quickly than some economists had expected), with the median dot plot suggesting three rather than four hikes. We explain why four hikes might have become more likely than three.
  • The press conference was shorter and less involved then under Chair Yellen, suggesting a lower degree of comfort with explaining the Fed’s thinking. However, this is still a long way from Alan Greenspan’s “constructive ambiguity” where markets would be deliberately kept in the dark about the Fed’s intentions.
  • Markets have been choppy since the meeting. We do not think it is right to attribute all the subsequent weakness to the Fed. Other concerns including worries about trade sanctions and if large tech companies may be more tightly regulated have weighed on markets.
  • Overall we still recommend clients remain underweight fixed income and be at benchmark on equities. We think that it will become increasingly important to diversify further and suggest increased exposure to alternatives.
A shift to four hikes?
Wednesday’s (21st March 2018) hike in the Fed Funds, the first of the year and the first by new Chair Jerome Powell, was widely anticipated by markets. Indeed option markets were putting a marginally higher probability on a ½% hike than no hike at all. Of more interest was what might be revealed by the Summary of Economic Projections and any clues that might come from the press conference. The now (in)famous “dot plot” where Federal Open Market Committee (FOMC) members say where they think the Fed Funds rate will end the year conditional on appropriate monetary policy being followed probably gets more attention than the Federal Reserve would like. Chair Powell was at pains to emphasize that the Fed remains data dependent. Where the median level of the dots is often seen by commentators as the Fed’s forecast of where the Fed Funds will end the year. A minority of economists were looking for the median dot to shift up suggesting a total of four hikes rather than three this year. 

The “Dot Plot”: no change to 2018 median but 2019 and 2020 higher 


They were disappointed but an excessive focus on the median ignores the more important dot: the one belonging to Chair Powell. Three of the five committee members who were expecting three hikes back in December have shifted to four hikes this year. Whilst we don’t know exactly which dots corresponds to which member, on the basis of speeches we suspect that the three movers would be from a group of Chair Jerome Powell, Bill Dudley (President of the Federal Reserve Bank of New York), Governor Randall Quarles and John Williams (President of the Federal Reserve Bank of San Francisco). If, and it is a big if, core PCE (personal consumption expenditure) inflation accelerates in line with the Fed’s forecast, it seems likely that we will have a total of four hikes this year.

Upside growth surprise?
Interestingly growth expectations have been shifted upward only by 0.2% to 2.7% for 2018 and 0.3% to 2.4% in 2019. This suggests that the Fed is at the lower end of what economists think is the cumulative impact of the Tax Cut and Jobs Act signed in to law at the end of December and the additional spending passed in February. The Fed conditions forecasts on what is signed in to law and at the time of the meeting so the forecasts can only be rationalized on the basis that they believe underlying momentum of the economy has weakened. Over 2016 and 2017 strong equity and real estate markets have helped $12.5 trillion to household net wealth. Whilst financial conditions have not been as conducive this year we still think that the historic wealth increases could lead to continued strength in consumption.

A shifted Phillip’s curve?
The median FOMC projection is for average unemployment in Q4 2019 to have fallen to just 3.6% - the lowest level since 1969, yet for PCE inflation to be only 2%. Economists have traditionally talked about a trade-off between the unemployment rate and inflation with the trade-off referred to as the “Phillips curve”: low unemployment leads to wage inflation which then leads to broader inflation.
 
It has long been recognized that the curve is not stable and is shifted by changes in inflationary expectations. However, in recent years some economists have suggested that the Phillips curve has become “flatter” (big falls in unemployment only boost inflation very slightly) or the relationship has broken down entirely and that low unemployment doesn’t increase inflation at all. Is the Fed implicitly endorsing this view by assuming that it can have a further fall in unemployment with no significant adverse impact on inflation? We think it is probably best to compare the unemployment rate with the acceleration or deceleration of inflation (in other words the second derivative of price movements). The Fed is forecasting that unemployment will fall below where they think the long-term equilibrium level is (4.2% to 4.8%) but this will help get inflation back up to levels which they’re comfortable with. The Fed thinks that running the economy with unemployment by over 0.5% below its equilibrium level will cause inflation to only accelerate by 0.1% per annum. This seems on the low side. It is of course possible that the equilibrium unemployment rate is in fact far lower than assumed. That would explain why we haven’t yet seen much in the way of inflation but it will also mean that if unemployment does get in to the mid 3% range it could accelerate more than expected.

An inflation overshoot?
In our view there were no nasty surprises. Some commentators have picked-up on the “overshoot” of inflation to 2.1% in 2020 and asked why the Fed would not want to achieve its inflation objective (of 2%) given that its employment objective has already been achieved. We think this misinterprets the Fed. In the same way that they have not been overly concerned about the inflation rate having been below target, they have emphasized that they’re also not too concerned by a temporary overshoot either and looking to minimize the overall deviations of unemployment and inflation from target levels. This policy is also sometimes referred to as “optimal control.” The Fed recognizes that the extraordinary fiscal policy boost (from last year’s tax cuts and this year’s expenditure increases) is likely to see a surge in growth which will likely cause acceleration in inflation. However, longer-term inflation and output stability is optimized by having a temporary overshoot rather than a big hike in rates now which whilst likely being effective at preventing inflation overshooting could cause inflation and output to drop when the fiscal boost fades.

Implications for our views
Although there were some short lived downward spikes, equity markets reacted well to the statement and the summary of economic projections. However, there was some weakness around and after the press conference and in trading the next day (Thursday 22nd March) We don’t think that this can all be attributed to the Federal Reserve. Worries about challenges to the dominance of the tech giants as well as concerns about trade wars continue to unnerve markets.
 
Fixed income markets have also been choppy. An initial surge in the 10 year yield, led by an increase in the yield on inflation protected Treasuries (TIPS), was reversed and yields ended up being slightly lower on the day. Yields fell further on the following day, with the curve flattening. The dollar has also been on a weakening trend with some commentators attributing this to a lack of commitment to the inflation objective.
 
Despite the increase in bond yields since the summer of 2016, we still think that equities offer better prospective returns than fixed income. Having said that, we advise against being overweight equities at this stage in the cycle. Diversification is becoming increasingly important. We think investors should be less reliant on fixed income and equity returns being negatively correlated and we suggest increasing exposure to alternative asset classes.
 
Derry Pickford is a Principal on Aon Hewitt’s Global Asset Allocation team, and is based in London, UK.   
 
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