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Suddenly very close to neutral

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11/29/2018 | 11:30am EDT

In front of the New York Economic Club, the Fed boss said that rates were very close to a neutral level, just weeks after saying the opposite. What changed? How many rate hikes can we expect in 2019?

Back in October, Jerome Powell had investors worried when he said that the Fed was "still very far" from the "neutral" rate to which it aspires. Otherwise known as the Goldilocks state, it is neither too hot or too cold, promoting growth without feeding price increases. Many believe that this statement from Jerome Powell has been a significant factor in triggering a period of turbulence on Wall Street.

But on November 28, he completely reversed its tune. Rates are now "just below" a neutral level, all of a sudden. By saying so, he signaled to markets that the rate hike cycle would be coming to an end sooner rather than later.

The planned increased will likely happen in December, but this could well mean that there will be less rate hikes next year than the 5 many anticipated.

Why has the Fed changed its course? After all, the US economy’s growth is on pace to exceed 3%, the unemployment rate is at a 48-year low, and inflation is right on target. But as we approach 2019, the question is how long will the good times last.

According to Goldman Sachs, not so long. In a new report, it estimates that growth is likely to slow significantly next year, “with tighter financial conditions and a fading fiscal stimulus to be the key drivers of the deceleration.”

Source: Goldman Sachs Global Investment Research

It notes that firmer wage pressures coupled with additional tariff rounds should boost core PCE inflation by the end of 2019. “While Fed officials would be comfortable with inflation at that level, we also see a risk of a more material inflation overshoot.”

Analysts at Jefferies agree that the economy will slow next year, and welcomed the Fed’s new stance: “A less active Fed could diminish future bank earnings, but it could also give a little back on reducing fears of a slowing economy”. Despite the dovish speech from Mr Powell, it still expects 5 more Fed hikes by mid-2020. This includes December 18, three hikes in ‘19 (Mar/Jun/Dec), and one hike in June 2020. “While this seems high after the speech, the reality is that for most banks, the incremental Fed hike is becoming far less additive as the rate cycle progresses, with rising deposit costs an ever more present offset. Further, we are already below consensus for many names on ‘20 EPS, which leads us to believe we are not much different on rates alone.”

Jefferies believes that a gradual Fed tightening is good medicine for the economy, and could bolster the stock market and lend confidence to the continuation of the benign economic environment characterized by low unemployment, decent GDP growth, and low inflation.

As mentioned earlier in this piece, it is one of many analysts that believes that the recent market turbulences were fueled by the fears that the Fed would hike too many times and curtail the already-long economic expansion.

Meanwhile, Goldman Sachs expects four more hikes in 2019. “With a large overshoot of its labor market target under way, the FOMC will likely be reluctant to stop until it is confident that the unemployment rate is no longer on a downward trajectory, a point we expect to reach only in early 2020.”

Romain Fournier
© MarketScreener.com 2018
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