The FOMC meeting concludes this afternoon with no change in rates or policy expected. The so-called “patient pause” that the Fed instituted earlier this year is likely to prevail, but with a press conference following every meeting the possibility exists for tradeable nuggets of insight. As we await the 2pm rate decision and press conference there are other items of note hitting the wires. The ADP Employment Change Report saw 275,000 new private sector jobs for April versus 180,000 expected and 151,000 in March. That bodes well for the Friday jobs report which is expected to be another solid read with momentum continuing after the weather-related lull in February. Perhaps more important to the market this time than continued job gains is the Fed’s recent comments about waning inflation pressures and wanting to get core PCE to, or above, the 2% target. We’ll be attuned to the post-meeting statement and press conference for comments and/or hints concerning a newfound willingness to let inflation track higher before attempting to arrest the rise with rate hikes. We discuss this in more detail below and will be back later this afternoon with a recap of the FOMC post-meeting statement.
With the FOMC rate decision later this afternoon (2pm EDT), the real drama centers around two disparate issues: first, is a cut coming to the Interest on Excess Reserves account, and second is the Fed really serious about letting inflation drift above the 2% target? Let’s tackle that first one as it’s more a technical issue and not one that speaks to a sea change in monetary policy.
With the effective fed funds rate trading at a cycle high of 2.45%, just 5bps from the 2.50% upper bound, the Fed is faced with a dilemma. In 2018 when the fed effective rate traded that close to the upper bound, they would simply raise the IOER by 20bps when hiking the funds rate by 25bps. This would provide more headroom between the effective rate and the upper bound, and it still resulted in a rate hike to the IOER. The dilemma now is that with no rate hikes expected anytime soon, if the Fed wants to limit the upward drift in fed funds they may institute a 5bps cut to the IOER rate to 2.35%. The issue there is communicating that the cut is not an easing of policy but rather an adjustment to the plumbing of the fed funds market. Investors may think too that if an IOER cut is effected could a cut in the fed funds rate be far behind? While we don’t expect an IOER rate cut at this meeting, it may warrant comments in the statement and/or press conference setting up the possibility at the June meeting.
The second issue revolves around assessing the Fed’s veracity in allowing inflation to drift above 2%. There have been comments from a few Fed members that indicate a tentative willingness to allow inflation to drift above the target recognizing that the series of nine rate hikes have kept inflation from lifting, and, in fact, recent trends have it moving lower and away from 2%. Core PCE in the first quarter was just 1.3% annualized compared to 1.8% in the fourth quarter.
With inflation running well below the 2% target, it affords the Fed the luxury of time to see if inflation stabilizes and indeed starts to rise toward the 2% target. The market, however, is pricing in a rate cut by year-end, assuming a slowdown in growth and/or further inflation weakening. We have a hard time seeing that as a realistic possibility given the solid first quarter GDP number and the beginnings of what looks like a rebounding consumer in the second quarter. If the labor market continues with monthly job gains of 200,000, and annual wage gains remain above 3.0%, consumer consumption is likely to rebound in the second quarter to something well above the 1.2% spending gain in the first three months of the year.
While first quarter GDP of 3.2% surprised to the upside the beat came as a result of positive one-offs in inventory and trade that are likely to be reversed in the second and subsequent quarters. That fact kept Treasuries rallying despite the headline beat. On Monday, personal spending numbers for March were released and reflected a huge pop in spending that argues the consumer is alive and well and will likely carry second quarter GDP to respectable gains, even if inventory and trade numbers reverse.
In fact, many of the March and early April reports reflect a rebound in economic activity after the soft patch at year-end. Thus, if that trend persists we find it unlikely the Fed will ease, even if inflation remains moribund. What’s more likely to occur is the Fed stands pat as it watches economic results, and with the ongoing gains in the labor market, rising wages will eventually lead to more demand-pull inflation that starts to push core PCE higher and closer to 2%.
It will be at that point that we test the Fed’s willingness to allow inflation to creep above 2% without a rate hike. Just like the Force was strong in Luke Skywalker, we think the inflation-fighting force within several members of the Fed is strong such that the closer core PCE creeps to 2%, the urge to hike may become overwhelming. Is that a 2019 event? Probably not. Second quarter GDP growth is projected at 2.5% and early forecasts for third quarter have it trending lower, but still respectable at 2.2%. That growth, along with continued job gains, should stabilize inflation, if not move it grudgingly higher, and that likely keeps the Fed from easing throughout 2019 with a rate hike a possibility at some point in 2020.
Rebounding Confidence Hints at Renewed Spending
We argue above that we really don’t see a fed funds rate cut by year-end. One of the reasons for our reluctance to sign on to a rate cut is the consumer seems to be making a comeback after the fourth quarter lull that extended into January and February this year. Personal spending in March rebounded with gusto and consumer confidence as shown in the graph has begun to rebound as well after the dip at year-end. While the first quarter beat in GDP was aided by one-off gains in inventory and trade, it looks like the consumer is prepared to pick-up the ball and run with it in the second quarter and that alone, given they are two-thirds of the economy, should be enough to keep second quarter GDP in the mid-2% range and the Fed stuck in pause mode for the foreseeable future.
Agency Indications — FNMA / FHLMC Callable Rates
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