I joined Chris Wolfe from First Republic Wealth Management on the set of Bloomberg’s Daybreak to discuss market developments and the outlook for the US economy. We generally agreed that while the economy is slowing it is doing so from unsustainably strong levels. We also are both highly convinced that the Fed will increase rates later this month, and anticipate two hikes next year. Investors, understandably with scar tissue from the Great Financial Crisis, fear that the end of the business cycle will be another credit crisis.
The market never accepted the Fed’s contention that three rate hikes in 2019 would be appropriate. Even this forecast of three hikes represented a moderation from the four hikes it anticipated this year. The real debate has been not whether the Fed pauses next year but when. Now, even the two hikes that the Fed funds futures had largely priced in have been taken back. Indeed, indicative pricing suggests the market sees the Fed likely pausing at the start of 2019. It is as if the market is bringing forward the end of the business cycle from 2020 to 2019.
Those who see the Fed pausing in Q1 19 appear to be basing their arguments on the slowing of the economy, moderation in price pressures, or trade tensions. The economy has been growing above trend, of the rate that Fed officials see as the long-term non-inflationary pace, which is closer to 2% than 3%. Provided the economy is growing faster than the trend, it is absorbing spare capacity and creating conditions that can lead to an increase in the general price level. With near full employment and above-trend growth, and important, though often forgotten, when adjusted for inflation, the Fed funds target rate is below inflation. Headline CPI was 2.5% in October. It is also averaged 2.5% this year. The current Fed funds target is 2.0% to 2.25%. In the past, it has taken a negative real Fed funds rate to provide the financial conditions that end an economic contraction.