Investment Insights: ‘Just below’
This weekly report presents insights from our Global Investment Management team.
What Powell was referring to was the current level of interest rates and their relation to what the market or economists call the “neutral range.” In a speech by Fed Governor Lael Brainard in September, she described a nominal neutral rate as “the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.” What Powell was referring to was that the Fed is currently just below a rate which is low enough to sustain growth for the economy but high enough to keep inflation in check. In other words, Goldilocks is searching for the porridge and plans on eating it, too.
The impact of these two words, and the relatively small number they imply, speaks to how the market interprets the words of a Fed Chairman. The neutral rate range is now generally thought to be between 2.5 to 3.5%. The Fed currently has set the federal funds target rate between 2 to 2.25%. Powell effectively could have said this for the last couple of rate hikes, and it would have been true as well; but at this juncture those words ring out across the market, suggesting fewer hikes on the horizon. Not surprisingly, the S&P 500 heard that and rallied hard, with the market up more than 2.3% to end the day.
The path taken to achieve the Fed’s ultimate objective of a neutral rate or range has been relatively effective in terms of supporting what would be considered a stable economic environment. Federal Reserve economists currently put the natural rate of employment at between 4.1 to 4.7%, and the U.S. is humming along at 3.7%. Stable inflation with the U.S. Personal Consumption Expenditure (PCE) averaging about 1.56% since the bottom of the recovery, per Bloomberg, is another box arguably checked off. And finally, GDP is expected to grow at 3.1% in 2018 after growing on average 2.2% each year over the past five, per Bloomberg. From the Global Investment Management team’s standpoint, the Fed is recording high marks for how it has used monetary policy to stimulate the recovery while normalizing rates “just below” the neutral range.
That’s not to say the next couple of years aren’t going to be more difficult. With fiscal stimulus expected to add less to next quarter’s economic growth; the anticipation that navigating a soft landing will be very difficult for the Fed; and the belief, in some corners, that they are already to blame for the next recession, the Fed has almost no room for error. More than likely, the Fed would like to push rates a bit higher and reduce the quantitative easing program to a balance sheet level below $3 trillion before the storm clouds of any pending recession gather.
For now, “just below” is good enough for a rally in the U.S. equity markets and doesn’t pose a threat to shutting off the equity rally for the next 6 to 12 months. The market will be concentrating on the macro picture once again as the majority of earnings reports are wrapped up. That means trade talks between the U.S. and China, the next episode of Brexit, and the final tally of consumer spending over the holidays will be front and center for the end of the year. For now, our team is holding allocations with a slight overweight to equities, slight underweight to fixed income, and a neutral allocation to alternatives.
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