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Powell speech sends equities soaring

By David Morrison  |  29/11/2018 16:08

Powell appeared to suggest that fed funds rate close to ‘neutral’, but that could be a misinterpretation

Yesterday evening the Federal Reserve Chairman, Jerome Powell, delivered a speech to the Economic Club of New York. The market reaction was stunning as US equity and bond markets soared in tandem while the dollar slumped. Traders interpreted Mr Powell’s comments as dovish, believing that he had signalled that the US central bank is close to pausing or even ending rate hikes. On the face of it, it does appear that Mr Powell has pivoted away from comments made back in October when he said the Fed was “a long way off” its ‘neutral’ level for interest rates. Last night he said that fed funds were "just below" the range of estimates for neutral policy.

Where’s ‘neutral’?

But there are a few themes worth considering here. For a start, even the Fed is still trying to work out what the neutral rate is. This was a point made by Federal Reserve Vice Chairman Richard Clarida earlier this week. Back in September, the Federal Reserve’s Federal Open Market Committee (FOMC) released its latest quarterly Summary of Economic Projections. In this, FOMC members put down their individual forecasts for future unemployment, inflation, GDP and interest rates. The range of where the 12 committee members felt the long-term neutral rate for fed funds should be stretched from 2.50% to 3.50%. So, in this respect, with fed funds currently having an upper band of 2.25% then Mr Powell only stated a fact last night when he said that fed funds were "just below" the RANGE of estimates for neutral policy.

Median point

But the median point of the FOMC’s estimates is currently 3.0% - in other words, three 25-basis point rate hikes above the current fed funds rate. Now, this forecast could change at the Fed’s next monetary policy meeting on 19th December. But if it doesn’t, that implies that rates could rise by 75 basis points before the neutral rate is hit. Assuming the Fed hikes next month, then there could be another two rate rises in 2019. Admittedly, this is one less than the FOMC forecast back in September, but it’s also one more than currently predicted by the markets.

Dangers exist

In addition, Mr Powell said that even after eight hikes since December 2015, rates are still low by historical standards. He also warned of the dangers in getting the pace of tightening wrong - moving too fast would risk shortening the US expansion, while moving too slowly could risk higher inflation. But the effects of Fed's gradual hiking are uncertain and could take a year to realize. This would seem to indicate that the US central bank may want to take a pause soon to assess the situation. Nevertheless, Mr Powell said he saw "great deal to like" about the US economic outlook, with low unemployment, inflation anchored around the 2% target and continued solid growth. But perhaps what also got traders rushing to hit the ‘buy’ button was Mr Powell’s statement that: “We will be paying very close attention to what incoming economic and financial data are telling us”. This implies the Fed is ready to shift away from steady rate increases of 25 basis points each quarter to being far more data-dependant. Given the concerns of a slowdown in global economic growth, investors now expect any evidence of this will cause the Fed to pause. The problem though is that a global slowdown will affect the US as well. This will make it more difficult for US corporations to boost sales and earnings going which should make investors reconsider corporate valuations going forward.
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