Great Expectations

The market response to last week’s Federal Reserve meeting and press conference was somewhat perplexing.  The interest-rate hike itself wasn’t a surprise – there was a nearly unanimous consensus among economists and other market participants that the Fed would increase the Fed Funds rate by 0.25%.  Rather, it was the interpretation of and  reaction to the Fed’s “forward guidance” that caught the market a bit off guard.

The Fed’s economic projections were “virtually identical” to those the central bank provided in December.  As such, Chair Yellen firmly backed a continued “go-slow” approach, which the Fed believes will result in just two additional interest-rate hikes this year.  Market expectations, on the other hand, were for an incrementally more hawkish Fed.  An improvement in the labor market, a pick-up in inflation and better economic data in recent weeks were supposed to result in the Fed raising its forecast for the number of interest-rate increases this year.  That didn’t happen.  But there were two very important caveats, without which the Fed’s interest-rate forecast might have been markedly different.

But first the market reaction. Following Chair Yellen’s Q&A session with the press, stock and bond prices spiked and the dollar sold off. The Dow ended the day up 113 points, and the yield on the 10-year fell by nearly 11 basis points to 2.49%. And while stock prices have leveled off since then, the rally in bonds continues. The yield on the 10-year currently stands at just 2.42%.  These are not the reactions of an investor base fearful of an overly hawkish Fed.  Rather, the reaction suggests monetary policy will remain quite accommodative.

Now let’s move on to those caveats.  First, Chair Yellen said that the Fed’s economic forecast, including its projections for interest-rate hikes, still does not make any presuppositions with regard to fiscal stimulus.   “We recognize that there is great uncertainty about the timing, the size, the character of policy changes that may be put in place and don’t think that that’s a decision or a set of decisions that we need to make until we know more about what policy changes will go into effect.”  Yellen is telling us that her crystal ball is no better than ours for predicting Congressional action.  Furthermore, it is important to note that not all of President Trump’s proposed policies would be stimulative for the economy.  Lower tax rates, reduced regulation, and increased infrastructure would almost certainly provide a boost to growth.  But other policies, like trade restrictions, could have negative ramifications.  In any case, there is very little doubt about what the markets have been expecting.  Markets have priced in fiscal policies that will improve economic growth rates.  Because the Fed is not incorporating any benefits from those proposed policies, it stands to reason that actual progress on Capitol Hill could result in the Fed needing to play “catch up” with regard to rate increases.

The second caveat was a bit more of a surprise.  Chair Yellen explained in her prepared remarks as well as during the Q&A session that much of the positive economic data we have received in recent weeks has come in the form of sentiment readings rather than hard economic data.  These “soft” sentiment indicators would include things like business and consumer confidence, homebuilder sentiment, and surveys such as the Institute for Supply Management and Purchasing Managers Index surveys.  At the same time, economic indicators that represent actual activity, such as those that gauge consumer spending, business investment, and wage growth have not been as robust.  Chair Yellen said, “it’s uncertain just how much sentiment actually impacts spending decisions, and I wouldn’t say at this point that I have seen hard evidence of any change in spending decisions based on expectations about the future.”  She went on to say, “most of the business people that we’ve talked to also have a wait-and-see attitude, and are very hopeful that they will be able to expand investment, and are looking forward to doing that, but are waiting to see what will happen.”

The Fed continues to walk a very fine line.  It’s economic forecasts, and therefore its monetary policy, continue to assume scant improvement in economic growth and no help from Congress.  Meanwhile, the markets seem to be pricing in both impending fiscal stimulus and an acceleration in economic growth.  The stage is set, and either the markets or the Fed will be wrong.  In the words of Mohamed El-Erian, “If improved confidence in the US economy does not translate into stronger hard data, unmet expectations for economic growth and corporate earnings could cause financial-market sentiment to slump, fueling market volatility and driving down asset prices.  In such a scenario, the US engine could sputter, causing the entire global economy to suffer, especially if these economic challenges prompt the Trump administration to implement protectionist measures.”

For our part, we continue to believe that the problem lies in the unbalanced nature of the economic recovery.  Consumer spending makes up over two-thirds of the US economy, and therefore the only way to achieve higher and more sustainable growth is through the implementation of policies designed to result in more widespread income and spending gains.  And the only way to do this is through initiatives designed to improve productivity.  Corporations must be incentivized to invest.  Investments must be made in education and training.  And, yes, the country’s infrastructure, from its bridges and highways to the power grid, must be improved.  Unfortunately, monetary stimulus has long since reached the point of diminishing returns.  The Fed’s blunt instruments (interest rate cuts, quantitative easing) are unable to adequately address the problem of stagnant wages and economic inequality.  Congress must act, and the sooner the better.