The Fed Emphasizes Patience

The Federal Reserve just made their most dovish shift in outlook since the aftermath of the financial crisis. The FOMC statement, economic projections, and "dot plot" (the expected path of rate hikes) all tilted dovish. In addition, the Fed has decided to maintain a significant portion of the bloated balance sheet it gathered during and after the crisis. In other words, their stated path of "renormalization" will leave the balance sheet well above normal levels.

Back in December, the median projection from the Fed was two rate hikes in 2019 and one more in 2020; now it's zero rate hikes this year and one in 2020. This shift reflects undue (in our opinion) pessimism about the economy. The Fed downgraded its forecast for real GDP growth to 2.1% this year from a prior estimate of 2.3%, while also revising lower their growth outlook for next year. As a result, the Fed now thinks unemployment will bottom at 3.7%, not 3.5%, and expects less inflation, with it's preferred measure (PCE prices) up 1.8% this year and 2.0% per year for 2020-21. That's a 0.1 percentage point reduction in inflation expectations for each of these years.

The statement, too, reverberated pessimism, noting a slowdown in economic growth, consumer spending, and business investment in the first quarter. It also acknowledged that overall inflation has slipped due to lower energy prices. We think the Fed is too pessimistic and that the US economy should grow in the 2.5 to 3.0% range in 2019, as it keeps absorbing the benefits of tax cuts and deregulation. We see the same slowdown the Fed sees for the first quarter, but think it's just statistical noise based largely on suspiciously weak consumer spending figures from the government that are inconsistent with other data.

The most disappointing news was that the Fed has decided to abruptly taper and end the renormalization of the balance sheet. Right now, the Fed is reducing it's balance sheet by up to $50 billion per month, consisting of $30 billion in Treasury securities and $20 billion in mortgage securities. Starting in May, the Treasury portion will be cut in half to $15 billion per month, while mortgage securities will continue rolling off at their current pace. Then, starting in October, the Fed will no longer reduce its Treasury position at all, but will instead take up to $20 billion per month in maturing mortgage securities and roll them into Treasury debt.