Fed Chairman Powell learned the hard way that his comments, even those made outside of official Fed communications channels, can move markets. The Fed is on a mission to make itself less important in the decision-making of savers, investors, consumers and governments.
The Fed is aiming to normalise its monetary policy and raise rates toward their neutral level – but the Fed also wants to make itself less relevant to market participants
In 2019, multiple factors could determine the timing, pace and composition of the Fed’s normalisation process, including the expansion of corporate debt, debt quality and unanticipated changes in the rate of inflation
Watching these potential influences on Fed policy can help investors anticipate FOMC actions and make appropriate asset-allocation decisions
Monetary-policy makers in the US will continue to push interest rates toward their neutral level, though that level is uncertain. As they do so, however, they will be watching conditions in financial markets very carefully for signs that liquidity may be becoming too tight or that individual segments of the fixed-income space are starting to founder.
To understand what lies ahead for US monetary policy, investors must not forget that the members of the Federal Open Market Committee are not just monetary authorities – they also are central bankers. As a result, the overall policy mix in 2019 will reflect the Federal Reserve’s overarching mission to return financial-market conditions to “normal” while also reestablishing the Fed’s independence and making its decisions less relevant, even irrelevant, to investors.
Think of the Federal Reserve in 2019 much as you would think of a business determined to do what it perceives to be in the best interests of its shareholders. In the case of the Fed, those shareholders are the largest number of US individuals and institutions for the longest period of time.
Accordingly, the Fed can be expected to act in 2019 as if its vision, mission and strategies are as follows:
Vision: to remain the world’s pre-eminent central bank by formulating and implementing policies that set conditions conducive to the achievement, in the US, of maximum, sustainable real economic growth with stable prices and stable, well-functioning banking and financial systems.
Mission: to fulfil the vision statement by normalising the balance sheet of the Federal Reserve System and the level and structure of interest rates in a manner that neither disrupts the flow of goods and services, money and credit, nor promotes the misallocation of resources in any market. Another aspect of this mission would be to make the Fed less relevant in the decision-making of participants in real and financial markets around the world.
Strategies: adjust the level of bank reserves and short-term interest rates, wind down holdings of Treasury and mortgage-backed securities, and use official communications to provide forward guidance to market participants and set expectations.
In carrying out this business plan, the Fed will continue to implement monetary policy as it has since the end of the financial crisis. Research within the Fed suggests that its operating procedures are working very much as expected, keeping the federal funds rate within its target range. Meanwhile, neither the rate increases since 2015 nor the normalisation of the Fed’s balance sheet since 2016 appear to have affected the economy and markets materially.
Comments by Fed Chairman Jerome Powell in August suggested that the FOMC might have to raise the target for its policy interest rates quite a bit further to get them to their neutral real level. However, after financial markets sold off sharply, Powell walked back his comments, telling an audience in New York that current money-market rates were indeed not much below neutral. A gleeful, but visceral, reaction shot through financial markets, if only for a day. The Fed Chairman learned again that his words count.
Here are factors to watch in 2019 that could determine the number of policy-rate increases and the timing, pace and composition of the Fed’s balance-sheet normalisation:
Communications from Jerome Powell – and, perhaps, Richard Clarida, Fed Vice Chairman – as well as official FOMC meeting minutes and press releases (but not from other individuals within the Federal Reserve System).
Indications that the labour market has tightened enough to push labour compensation increases substantially above 3%. Read the so-called “beige book” to find out whether the Federal Reserve Bank presidents are hearing that the tariffs are raising their costs, wage pressure is rising and businesses are raising prices successfully.
Indications that exogenous factors (like changes in oil prices) have become embedded in consumer prices and become endogenous. If so, inflation will go up – as will inflationary expectations – and the inflation premium embedded in long-term interest rates will increase.
Productivity data and estimates of term premiums, both of which influence Federal Reserve estimates of the neutral real short-term interest rate.
PMI and ISM readings, both for manufacturing and nonmanufacturing companies. These data provide an excellent indication of the strength of the national economy and pricing.
Corporate earnings growth that may be slowing. It will be important to look at the quality of earnings – how much is from unit sales, how much is from price increases, how much is organic and how much came via acquisitions. Other factors to watch are the international economic, financial and currency-related conditions as non-US central banks begin removing monetary accommodation and face political and financial challenges.
Are the financial markets operating in an orderly fashion or have they become disorderly, making price discovery impossible, counterparties impossible to find and trading too fast for human market participants to adjust positions when desired?
Fixed-income and credit market conditions, including sovereign debt, corporate debt, and particularly high income and leveraged loans.
Above all, liquidity conditions across the yield curve and in individual markets.
Focusing on these potential influences on Fed policy can help market-watchers anticipate FOMC actions before they occur, and help financial professionals make asset-allocation decisions that will be in their clients’ best interest.
For an in-depth exploration of this topic, read the December 2018 edition of Under the Macroscope.
Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Bond prices will normally decline as interest rates rise. The impact may be greater with longer-duration bonds. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.
The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.
This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors Distributors LLC, distributor registered with FINRA, is affiliated with Allianz Global Investors U.S. LLC; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors (Schweiz) AG, licensed by FINMA (www.finma.ch) for distribution and by OAKBV (Oberaufsichtskommission berufliche Vorsorge) for asset management related to occupational pensions in Switzerland; Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association and Investment Trust Association, Japan]; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.
Europe’s economic slowdown makes the proposed normalisation of ECB monetary policy harder
The European Central Bank’s gradual normalisation of its monetary policy should continue, but the economic slowdown in the euro-zone will likely delay any rate increases, and the window of opportunity is becoming increasingly narrow.
At its meeting on 24 January, the ECB should consider the economic slowdown seen in the euro-zone’s four largest economies during the fourth quarter of 2018
To avoid a sharp slowdown in financial conditions, the ECB should discuss the possibility of new liquidity programmes targeted to meet the needs of banks
In the context of economic slowdown and a possible pause in rate hikes by the Fed, the normalisation of the ECB's monetary policy is becoming more complex