Fed Raises Rates Like Expected

The Fed raised rates 20 basis points like the market expected. However, the unexpected part was the change to guidance. This is a situation where a small change made a big difference. The Fed went from 6 officials thinking there should be 3 hikes this year and 6 Fed members thinking there should be 4 hikes to 7 thinking there should be 4 hikes and 5 thinking there should be 3 hikes. Only one out 12 officials changed his mind; this was a very small change in guidance which is having big impact on the markets. As you can see in the chart below, the dot plots have changed. The fact that one policy maker expects rates to be cut by 2020 and two expect rates to be above 4% in 2020 show how wide the swath of thinking is. Luckily policy changes usually don’t rely on one member because relying it is a precarious situation.

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Hawkish Hike

The impact was already felt on Wednesday’s market as traders decided this was a hawkish hike. Hawkish hikes have been rare in this cycle as the Fed has taken baby steps when hiking rates. Usually the Fed tries to avoid the volatility that comes with higher rates by giving dovish guidance. The problem with that combination is it’s unsustainable. There are only a certain number of hikes which can be taken away while the Fed still hikes rates.

It’s very important for investors to avoid acting in the heat of the moment which is difficult when the action can be volatile on a minute by minute basis. It’s fine to react quickly if you’re only looking at charts, but if you want to process this change in Fed policy, it takes a clear head. The fact that just one member changed his mind means the Fed can easily reverse that decision if the data changes or the stock market sells off.

Did The Rising Stock Market Play A Role?

Policy makers won’t admit that they look at the stock market, but they do. The stock market has risen since the last meeting, so that might have played a role in the guidance change. There’s a possibility that the improved economy in Q2 made a Fed official more hawkish, but the Fed really shouldn’t be making policy decisions based on a couple months of data. There are also increased risks in emerging markets which have sprouted up and a slowing European economy, so I feel that the fundamentals have been neutral. On the other hand, stocks have risen steadily up until Wednesday with momentum bringing the S&P 500 close to a new record. If the Fed follows the market, eventually these rate hikes will cause a correction which will cause it to cut guidance before it even gets to hike rates 2 more times this year.

Unemployment Guidance Change

The change in the Fed funds rate reflects the Fed’s outlook for other metrics. The table below shows the changes which are highlighted. The projection for the unemployment rate in 2018 changed from 3.8% to 3.6%. That’s a big change for this year since it’s already almost halfway over. If you were to look at the expectation for the unemployment rate a few quarters ago, clearly the Fed was completely wrong. The unemployment rate has gotten much lower than they thought it would.

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The unemployment rate is currently 3.8%. Given the growth in the labor market, it’s difficult to disagree with the Fed’s new target for 3.6%. It could end the year slightly lower, but probably not by much. Finally, the expectation for the unemployment rate in 2020 fell from 3.6% to 3.5%. Just like how the long term projections for the unemployment this year were proven wrong, I think that one will look silly. If a recession occurs in 2020, which I think is a possibility, the unemployment rate will be much higher than 3.5%.

Inflation Guidance Change

The outlook for PCE inflation and core inflation also changed. As you can see, the expectation for PCE inflation this year increased 2 tenths to 2.1%. That’s a pretty big difference just like the change in the unemployment rate. However, I give the Fed a pass for that mistake because the PCE is being driven by oil prices. Oil prices are difficult to predict in the short run and the long run. The core PCE estimate changed from 1.9% to 2% this year. That’s a bigger difference in my view. Clearly, the year over year rate is being helped by the easy comparisons. The higher rate usually means more hawkish policy.

I am surprised in this case because the Fed said in its Minutes that it would be fine with inflation running slightly above 2%. That means there won’t be any more rate hikes because of the slightly increasing core PCE.  This change in 2018 guidance goes against the Minutes. Since it was only one Fed official whose mind was changed, it’s easy to see why the Minutes and the current guidance differ. The Fed officials who had 4 hikes this year, weren’t going to change because of slightly higher core PCE and all but one of the Fed officials who had 3 rate hikes this year were stagnant.

2019 Rate Guidance Change

The expected rates in 2019 changed from 2.9% to 3.1%. That’s because the Fed expects to raise rates 3 times in 2019 still even though it added one more rate hike in 2018. Since the long run Fed funds rate is 2.9%, that means the 2019 rate will be above the natural rate which makes the Fed hawkish. I think the 4th rate hike this year will put it at contractionary policy, but that’s up to interpretation. This also means there will only be one hike in 2020. The Fed is going along with rate hikes as long as it can. If the economy keeps up strength in 2020, we might see even more than one hike. I think the economy will be in a position for rates to be cut in 2020, but right now that guidance isn’t relevant because it’s so far in advance.