Fed policy update: A single rate hike likely in 2019

January 11, 2019

 
Joe Davis

Joe Davis

Anxious investors, take heart: The U.S. Federal Reserve hears you.

Policy uncertainty and market volatility have prompted us to revise our expectations for the Fed's target for short-term interest rates in 2019. Our new baseline forecast is for a single additional rate increase, the tenth since December 2015 and perhaps the final hike of the current monetary-policy cycle. It represents a change from the 2019 outlook we published little more than a month ago, which I described in Fed outlook for 2019: A pause is coming.

To be sure, Fed policymakers themselves have signaled in recent days a willingness to reconsider their path forward. Not long ago, that path included as many as three expected rate hikes this year. The latest forecast from the Fed's policy-setting Open Market Committee anticipates a couple of 2019 rate increases. Meanwhile, bond investors in aggregate now suspect the Fed will stand pat, keeping its current target of 2.25%–2.5% in place for a while. Thus, our revised baseline estimate of a one-more-and-done approach to rate-setting this year puts us between the Fed's own crystal ball and that of the bond market.

Markets underestimated the Fed in 2018 and are doing so again for 2019

Markets underestimated the Fed in 2018 and are doing so again for 2019

Notes: The historical federal funds rate indicates the midpoint of the target range. Market forecasts reflect implied pricing from federal funds futures. Data are as of December 31, 2018.

Sources: Vanguard, Bloomberg, and the Federal Reserve.

To treat the future with the deference it deserves, however, we believe economic and market forecasts should be expressed in terms of probabilities. We don't pretend that only one outcome can occur. Instead, we consider baseline, or most likely, scenarios, as well as potential outcomes to the upside and downside. Here are our revised expectations:

  • Baseline: The Fed will hike rates just once in 2019. Our revised expectation is based on an analysis of current policy uncertainty and anticipates that the current level of financial market volatility will persist through the first quarter. In this case, the likelihood that market volatility will dent the real economy—the production of goods and services and their consumption—is high. We expect the Fed to hold its rate target steady for several months before raising rates, likely in June. Our forecast of the risk of U.S. recession in this scenario now stands at 35%, up marginally from 30% in the outlook we issued last month.
  • Upside: Policy uncertainty and market volatility significantly recede before the end of the first quarter. In this case, there's a higher likelihood that the Fed will raise rates twice this year, as we initially forecast. A second hike would lift the Fed's target to 2.75%–3.00%. This was our baseline scenario in early December, but given recent conditions we now view it as the upside.
  • Downside: Policy uncertainty and market volatility persist through the first half of the year. In this scenario, economic fundamentals are likely to be damaged and the Fed is likely to take a pass on any additional rate hikes. If the Fed does not raise rates by mid-2019, its window of opportunity could close and the next change in the target rate will likely be a reduction.

While we've revised our outlook for Fed policy, our investment outlook remains unchanged. Several factors will raise the risk of recession this year, but a slowdown in growth, led by the United States and China, is the most likely outcome. We also forecast:

  • Periodic growth scares, sparking elevated levels of market volatility.
  • That inflation should remain in check, in the range of 2% or less, but an escalation in tariffs, oil prices, or wages could alter that outlook. Even if price increases accelerate, however, our research shows that inflation-caused recessions have become rarer as a result of more proactive central bank action and anchored inflation expectations.
  • That U.S. economic growth is likely to decline toward 2% this year, amid decreasing support from federal tax and spending policies and continued monetary policy normalization. Higher wages are unlikely to funnel through to consumer prices.

For additional perspective on what the future may hold for investors, please see Economic and market outlook: Down but not out.

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
  • Investments in bonds are subject to interest rate, credit, and inflation risk.

 

Our insights straight
to your inbox

Our insights straight to your inbox

Receive our latest Advisor's Digest
research
and commentary sent the
first business
morning every week.

A weekly digest of our latest research and commentary. Topics include the economy and markets, portfolio strategy, ETFs, and practice management.


Fund openings/closings, fund manager changes, dividend distributions, webinars, and other events you might want to know about.



Already registered? Log on to
manage your
email subscriptions.