A December 2018 Fed hike looks likely, with the markets pricing a 4 in 5 chance that it happens. Yet, what may 2019 hold?
Tightening, But How Fast?
The consensus of the markets for 2019 interest rate moves is quite finely balanced at this point, but suggests more rate increases. Currently the most likely option seems to be a single hike in 2019, especially after Powell's recent statements that rates were "just below" neutral, rather than a "long way" from neutral as he'd stated previously. Quite an abrupt shift. Nonetheless, between zero and three increases are possible in the market's view. This is lower than, the Fed policy maker's expectations of between two and five hikes in 2019, but the most recent projections we have from the Fed were in September and October's seen weaker equity markets, a falling oil price and some concerning global data since then. So what data will the data-dependent Fed be especially focused on?
Weak Spots The Fed Will Be Keeping An Eye On - China, Housing, Energy and Agriculture
The Fed is data-dependent its approach, and high on that list currently is the Chinese economy. China is significant source of global growth, it's both a large global economy and seeing among the fastest growth anywhere. Any material slowdown in the Chinese economy could downgrade global growth prospects, so the Fed is closely monitoring Chinese trade tensions with the U.S., and any major moves in the Chinese currency, the renminbi.
U.S. housing is also an area of focus, home buyers are deterred by rising mortgage rates on recent data. Plus, since the Fed's last meeting, activity in the energy sector will be closely watched. Increasing energy investment to grow U.S. oil output was a theme in much of 2018. Yet, November's extremely sharp fall in the crude oil price may change that and have other knock-on impacts for the broader economy, that could be more positive. The agricultural sector is also a potential source of risk, as various products are hit by tariffs hurting profits. Of course, these are some of the weaker areas of the economy right now, and the Fed will as always keep a very close on inflation and employment trends, which are, so far, favorable on current readings as well of new sources of concern inevitably popping up. President Trump's comments on Fed policy too may present a wild card, but the impact of them, on a supposedly independent Fed is unclear.
Change To Rotating Seats May Make Consensus Harder
In January 2019 the heads of the Reserve Banks of Richmond, Atlanta, San Francisco and Cleveland will rotate off the decision-making committee and the heads of Chicago, Boston, St Louis and Kansas City will rotate on, as is standard. In practise, this is less extreme than it sounds as most Fed voting members typically don't change, so the effect can be minor, especially since the members of heads rotating on have been participating in meetings in a non-voting capacity throughout 2018, so have had some influence on decisions and are not coming in cold.
Nonetheless, it is these Reserve Bank Presidents who for the past decade have been most likely to dissent. In addition, in 2016 Esther George, of the Reserve Bank of Kansas City did dissent a combined total of five times when she was last a voting member for a full year, which is extremely high relative to others. Even though her recent speech on monetary policy has not deviated much from consensus Fed thinking, and she did vote with consensus in two summer Fed meetings this year as an alternate. So far Powell has built an iron-clad consensus with no dissent at any meeting he chaired. Indeed, the economic picture in 2019 is quite different to 2016 when George dissented so frequently. Nonetheless, it may be trickier for Powell to build complete consensus with George as a full-time voting member in 2019, and indeed most Fed chairs see dissent at some point so it would be surprising if Powell avoided it entirely over his term as chair. Charles Evans, of the Chicago Fed, has also signalled a desire to see more normal interest rate levels. Though that said, most of the members rotating off are also considered fairly hawkish, meaning they have a greater inclination to want to raise rates than average. So it is unclear if the incoming Reserve Bank heads are truly more hawkish than the outgoing group.
A Flattening Yield Curve?
The other thing to keep a close eye on, though not directly controlled by the Fed, will be the slope of the U.S. yield curve, often measured as the difference in yield on 2 and 10-year Treasury instruments. Currently that difference is extremely small relative to history. Yet the yield curve hasn't inverted, which is where short term rates are above longer term rates. When that happens it can be a negative sign and will grab headlines. It wouldn't take much of a move in the yield curve to get us there. The implication is that the tightening cycle has ended, but in a bad way, because a recession could be on horizon.
So the markets, and the Fed decision-makers, expect to see rates continue to go up in 2019 somewhere between one and four times, with fewer hikes more likely. Yet, how fast that happens depends on how the Chinese, indeed U.S., economies hold up in the presence of ongoing trade tensions, and how the current weaker spots in the U.S. economy play out.
