Fed leaves interest rates unchanged: What comes next?

A perspective from E*TRADE Capital Management, LLC 03/20/19

Unless you favor long odds, today’s decision by the Federal Reserve to keep interest rates unchanged was about as surprising as the sun rising in the east. Indeed, Federal Reserve Chairman Jerome Powell hinted last month that the Fed’s three-year campaign of interest rate hikes was coming to a close. Anything other than leaving the federal funds rate at its current target range of 2.25%-2.50% would have come as quite a shock to most market watchers.

But what is different: The central bank’s neutral stance marks a notable shift from last year, when the Federal Reserve seemed poised to lift interest rates well beyond where they stand now. As recently as December, the Fed’s own policymakers on the Federal Open Markets Committee (FOMC) expected the federal funds rate to land a hair short of 3% in 2019. Earlier forecasts had the benchmark rate going even higher.1

FactSet Research Systems, March 19, 2019

Diminished expectations for growth

What changed over the ensuing months?

In a word, expectations. Powell indicated earlier this year that the Fed’s expectations for economic growth had eased. “Financial conditions tightened considerably late in 2018 and remain less supportive of growth than they were earlier in 2018,” said Powell. “And, while most of the incoming domestic economic data have been solid, some surveys of business and consumer sentiment have moved lower, giving reason for caution.”2

Economic indicators weaken

Since those statements, Powell’s tempered outlook has largely been borne out by economic data:

•  Real gross domestic product (GDP) increased 2.6% in the fourth quarter of 2018. While that topped estimates, it’s still a sizeable decrease from the third and fourth quarters, when GDP grew by 4.2% and 3.4%, respectively.

•  US employers added a scant 20,000 jobs in February, well below forecasts. By comparison, in 2018 employers added an average of 220,000 jobs per month. Construction and retail saw some of the biggest declines.

•  New home sales fell by 4.1% on a year-over-year basis in January, which marked a nearly 7% decrease in sales from December.

•  Industrial production has weakened, with February’s ISM Manufacturing Index falling to its lowest level since November 2016.

You can see why Powell has taken what he calls a “patient approach” to monetary policy.

Still, the news isn’t all bad. With US unemployment at 3.8%, hourly earnings are on the rise and the labor market remains tight. By many measures, the US economy is still strong. But what matters to the Fed are future growth prospects, and the decision to back off from earlier forecasts of two to three rate hikes in 2019 speaks to the Fed’s measured expectations.

Investor takeaways

For investors, today’s decision comes with mixed signals:

•  Keep an eye on inflation: Powell has recently said that inflation is “muted,” which means there’s little risk of the economy overheating, in his view.3 That likely signals that rates aren’t going higher anytime soon, which has typically boded well for the markets.

•  Low rates could stimulate lending: The housing market needs a boost, and an end to rising interest rates could provide just that—especially with spring house hunting season just ahead. Low rates can also stimulate lending across any number of sectors, which can jump-start economic activity.  

•  Don’t ignore defense: While the markets cheered the Fed’s most recent decision to leave interest rates unchanged, it’s important to remember why the Fed has done so: financial conditions are less supportive of growth. For that reason, now may be a good time for investors to take inventory of their holdings. High-quality bonds and defensive stocks can help smooth market volatility if the markets get jittery about decelerating economic growth. In fact, utilities—traditionally viewed as defensive—have generated double-digit returns year-to-date through mid-March.

•  Company fundamentals matter: While growth stocks have outpaced value stocks over the past decade, that could change if economic growth slows and asset performance becomes less correlated. In this type of environment, individual stock selection and a focus on company fundamentals could assume renewed importance.

CME Group, March 19, 2019

The Fed’s next policy-making meeting begins in late April. As it stands now, the CME Group’s FedWatch Tool, which is based on fed fund futures contract prices, predicts no rate hikes at that meeting and a roughly 3% chance of rates moving lower.4 A lot can change in a month, but for now the Fed appears to be content keeping watch from the sidelines. How the US economy and financial markets respond remains to be seen.

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1. Board of Governors of the Federal Reserve System, December 19, 2018, https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20181219.pdf

2. Board of Governors of the Federal Reserve System, Transcript of Chairman Powell’s Press Conference, January 30, 2019, https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20190130.pdf

3. Bloomberg, “Fed's Powell: 'Muted' inflation gives room for wages to rise,” February 28, 2019,  https://www.reuters.com/article/us-usa-fed-powell/feds-powell-muted-inflation-gives-room-for-wages-to-rise-idUSKCN1QI39Y

4. CME FedWatch Tool, March 19, 2019, https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

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