The Fed has found the right balance

by Franck Dixmier | 29/04/2019
Building facade


With the US economy slowing and inflation low, we expect the Fed to confirm a pause in its monetary policy normalisation. Given the controlled slowdown in the US economy and equity-market momentum, we believe the Fed has found the perfect balance.

Key takeaways

  • The Fed’s rate-hike plans are on pause, and we don’t expect any surprises from its 30 April/1 May meeting
  • Given US growth prospects and inflation expectations, there’s no reason for the Fed to change course: it has found the right balance to remain "behind the curve"
  • We expect the Fed’s stance to confirm the markets’ confidence; they are no longer expecting a rate hike

We believe that the US Federal Reserve has found the right balance with its monetary policy, and that it will continue to put its normalisation plans on pause by holding off on rate hikes until 2020. This is a coherent strategy given the economic situation in the United States, with the “beige book” – the Fed’s survey of economic conditions – confirming that economic activity is slowing.

At the same time, dynamic household spending should help the US economy avoid a hard landing, despite a reduction in fiscal stimulus and lingering trade tensions. Moreover, inflation remains stable despite wage increases – an anomaly that could be explained by higher productivity and the reluctance of companies to pass on price increases to consumers given deteriorating economic conditions.

However, the minutes of the 20 March Federal Open Market Committee meeting revealed the Fed’s growing concern about low core inflation and historically low inflation expectations. The core consumer price index (CPI) and personal consumption expenditures (PCE) have been falling since mid-2018.

Still, nothing today seems to justify a course change, either upwards or downwards, in the medium term. On the one hand, the conditions for a rate increase have not been met:

  • The Fed seems to be moving towards a flexible approach that targets an average inflation rate, tolerating the times when it temporarily overshoots its 2% target as a way to compensate for the times it undershoots that target. This new approach is at the heart of the Fed’s strategic review, led by Vice Chairman Richard Clarida, of its monetary policy, tools and communication. Even though the conclusions aren’t expected before the end of 2019, FOMC members are likely thinking about this new strategy. This would justify the Fed accepting a slight inflation overshoot – without a rate hike – in the event the economy overheats. It is also consistent with the Fed’s approach to remain “behind the curve” as it intentionally avoids raising rates at a pace that keeps up with inflation.
  • Another reason a rate hike is doubtful is that an acceleration in wage-induced inflation at this stage of the cycle would be unlikely to last.
  • Given the markets’ firm expectations for a rate decrease, an isolated rate hike could have damaging consequences and would likely be perceived as a monetary-policy mistake. A rate hike could only be part of a cycle of a few hikes – a stance difficult to justify in the current context.

On the other hand, the conditions for lowering rates have not been met either. Only a below-potential growth rate, a less-buoyant labour market (with rising unemployment and a decline in job creation) and a sharp tightening of monetary conditions could justify further easing. However, there is no evidence of these elements in the leading economic indicators.

The Fed has therefore found the perfect balance, in our view, given the controlled slowdown in the US economy and equity markets returning to their mid-2018 levels, creating a significant “wealth effect”.

We don’t want to overlook President Donald Trump's attempts at interfering in the Fed’s independence, such as calling for lower rates or pushing for controversial appointments. These efforts are clearly a concern for central bankers, whose credibility is built over the long term. However, the Fed's arguments are convincing and powerful enough to prevent us from thinking that the pause in monetary-policy normalisation is the result of political intervention.


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About the author

Franck Dixmier

Franck Dixmier

Global Head of Fixed Income, CIO Fixed Income Europe

Franck Dixmier is Global Head of Fixed Income and Chief Investment Officer (CIO) Fixed Income Europe, and a member of the Global Executive Committee at Allianz Global Investors.

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