Multiple Narratives

In the last couple of years, Nobel Laureate Robert Shiller has championed the idea of economic narratives. Economic data describe “the fundamentals,” but stories are often the key drivers of activity. Investors are currently faced with two competing narratives. There are no signs that the economy is in a recession or about to enter one. However, the risks to the economic outlook are weighted to the downside, and many market participants fear a downturn later this year or in 2020. Over time, these two narratives ought to evolve in a way that brings them closer together.

Stock market participants were upset in mid-December when the Fed signaled an expectation of further increases in short-term interest rates. The dot plot showed that most senior Fed officials thought it would be appropriate to raise rates one, two, or three times in 2019 (with a median of two). Market sentiment turned more positive recently when Fed Chairman Powell signaled the policy would be flexible and that the central bank could afford to be “patient” in deciding when to raise rates. This was nothing new. In his post-FOMC press conference of December 19, Powell noted that inflation has been “a touch below” the 2% goal, which “gives the Committee the ability to be patient in moving forward.”

Scott Brown
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From the beginning, the Fed viewed the unwinding of its balance sheet as “background,” not active monetary policy. The Fed allows up to a certain amount of maturing securities to run off each month. The pace would not be adjusted to influence economic activity. The Fed’s asset purchase programs (QE1-3) are thought to have lowered the 10-year Treasury note yield by about 100 basis points. Accordingly, the decrease in the balance sheet should put upward pressure on bond yields. However, the unwinding is expected to occur over a few years and will not return the size of balance sheet to where it was before the financial crisis. Instead, the 10-year Treasury note yield has declined. That doesn’t mean that the balance sheet unwind hasn’t had an impact. Rather, there are a number of factors acting on long-term interest rates. The bigger concern about the balance sheet unwind is the effect on bank reserves. The FOMC minutes showed that the Fed is considering a number of technical adjustments to the federal funds market. Chairman Powell said that the balance sheet unwind did not appear to be a factor in recent financial market volatility, but the Fed could adjust the pace if that proved otherwise. Moreover, while nobody, including Fed officials, knows where the size of the balance sheet will end up, it is now likely to be higher than it was expected to be a month ago.