Yesterday the Fed Open Market Committee (FOMC), which sets monetary policy, released the minutes from its most recent meeting on January 29-30. In those minutes was a new buzzword that Fed-watchers are trying to interpret as it pertains to interest rates and the Fed’s balance sheet. I’ll discuss what I think it means as we go along today, but first a little background.
In the wake of the financial crisis of 2008-09, the Fed aggressively bought US Treasuries and mortgage-backed securities in an effort to stimulate the economy in a process referred to as “quantitative easing.” The Fed’s balance sheet exploded from under $1 trillion in 2008 to a record $4.5 trillion in 2015.
Starting in 2016, the Fed began to slowly reduce its balance sheet by letting maturing securities roll off the books (not replacing them with new bonds), referred to as “quantitative tightening.” Since late 2017, the Fed has been allowing a maximum of $50 billion per month in Treasuries and mortgage-backed debt to roll off its balance sheet. The Fed’s current balance sheet is estimated to be down to apprx. $3.8 trillion, which is still staggering.
Late last year, Fed Chairman Jerome Powell was asked how long the FOMC might continue raising the Fed Funds rate and reducing its balance sheet in this fashion. His initial answer was that policy was on auto-pilot, meaning it could go on indefinitely. Stocks immediately fell off a cliff in December and erased all the previous gains for last year.
On January 4, Powell attempted to ease investors’ concerns by saying that the Fed could be “patient” in raising interest rates and reducing its balance sheet. He also indicated that the Fed expects the US economy to slow this year and inflation to remain low, so the Fed had the ability to “wait and watch” before raising rates further and resuming its balance sheet unwind. The stock markets loved it!
And that gets us to the minutes of the January 29-30 FOMC meeting which were released yesterday.
The main takeaway from the latest minutes is that members of the FOMC are conflicted on what to do with policy this year. The Fed’s latest projections show the US economy slowing in 2019 to a pace of 2.5% or slightly lower, and it expects inflation to remain tepid. So, some FOMC members argued for a halt in raising the Fed Funds rate and further balance sheet reduction.
Others believed the Fed should continue hiking the Fed Funds rate, although not too much, so they have more room to lower it when the next recession arrives, and that the balance sheet reduction should continue.
That’s a big difference in opinion on how to go forward! So, what’s the Fed to do in such a situation? They gave us a new word to keep us guessing. This time, they added the word “flexible” to their policy guidance. How convenient! Translated, that means:
We don’t have a clue about what’s going to happen just ahead, or what our policy should be, so we’re going to wing it and try to figure out the correct policy as we go along. So, we’ll just add a new word: “flexible.”
What most of the FOMC members did agree on is that this policy uncertainty needs to end this year. Duh! They are hoping that economic data just ahead will send them clearer signals on which way to direct monetary policy. I think we could all agree on that.
So, what are we as investors to take away from the Fed’s latest flexible policy guidance? About the only takeaway I see is that it’s not bearish for stocks or bonds in the near-term. The FOMC now seems to be comfortable raising the Fed Funds rate only one time this year (and maybe not at all), instead of 2-3 times as they signaled last year.
The Fed expects the US economy to slow from 3% growth last year to around 2.4% this year. I see a lot of forecasts in that range for 2019. That does not suggest a recession just ahead, but it doesn’t stop the flurry of predictions that an economic downturn is inevitable this year. What else is new?
The bottom line is: I don’t see any major changes in the economy this year; I don’t see a bear market in stocks just ahead; and I won’t be surprised if stocks rise to new record highs in the coming months.
What I think will be the most interesting thing to watch this year is how far the Democrat Party veers to the left, and how much support for socialism grows (or not), as we approach the 2020 general election. But that’s veering way off topic, so I’ll leave it there for today.
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