How the Fed's Changing Tone Might Affect the Economy
By Sean O'Connell
February 26, 2019
How the Fed's Changing Tone Might Affect the Economy
Since the beginning of 2019 the financial markets have continued to exhibit the heightened volatility that began in early 2018. This volatility follows an unprecedented five-year stretch of historically-low levels for the VIX. The VIX is CBOE’s volatility index — widely regarded as the ‘fear gauge’ for the overall market. We have also witnessed one of the greatest January rallies on record as stocks bounced from recent lows made during a tumultuous December of 2018. Looking at the year ahead, there are multiple headwinds that face the markets for the remainder of 2019 and beyond. Among the most notable risks; are fears of slowing global growth, trade skirmish concerns with China, uncertainty with the stance of the US Federal Reserve bank, and the geopolitical risks that face the U.S. With all of that being said here is a recap of the FOMC (Federal Open Market Committee) January meeting minutes that were released yesterday, and how that might affect your wealth.
Whether or not the Fed will hike rates in 2019 remains a hotly debated topic across all of Wall Street even after the minutes from the January’s meeting were released yesterday. Following comments from the January meeting there is indications that the Fed will hold off on additional rate hikes for now and instead tweak its other lever for controlling monetary policy: the balance sheet. In the second half of 2019, the Fed may look to stop unwinding and begin normalizing. Many have already pointed to this potential next step as a reflection of a more “dovish”. The Fed, by making the decision to influence monetary policy through balance sheet operations and just listen for the time being, is claiming to act in a more data-dependent manner than they had indicated during different points of 2018. It was a widely agreed-upon decision by the Fed to inform the public about their intention to end the runoff at this time, hoping to put to rest some of the uncertainty that has affected the market.
Let’s take a brief pause…
“Dovish”
“Data-dependent”
“Balance sheet normalization”
What does all of this mean?
There are two spheres of influence that the US Government conducts that affect the United States economy. The first is Fiscal Policy. This entails spending/allocation and tax decisions that are the result of legislative action taken by Congress. The second is Monetary Policy, and this is regulating the cost of borrowing money and the money supply in the economy to control inflation, promote overall economic stability, and maintain robust employment levels.
The Federal Reserve is an independently-operated government entity that controls the U.S. Banking System, and through the FOMC, controls monetary policy in the United States. There are two main mechanisms that the Federal Reserve uses to control monetary policy in the US, the target Federal Funds Rate as well as manipulating the balance sheet.
To understand how the Fed will act to help the economy through its influence on the banking system, we will us the Financial Crisis as an example due to it being the most recent and most tied to current conditions.
The Fed, by making the decision to influence monetary policy through balance sheet operations and just listen for the time being, is claiming to act in a more data-dependent manner than they had indicated during different points of 2018.
When the events of the Financial Crisis of 2008 transpired there was a widespread of fear and unrest within markets and the broader economy. Firms and individuals were hesitant to deploy any capital that remained because of the general uncertainty that surrounded some of the institutions previously considered incredibly stable. The Fed enacted expansionary Monetary Policy of epic proportions to stimulate the economy. First off, they cut interest rates to zero — nominal rates remained at zero until 2015. At a time when lenders were weary to lend because of credit risk, and borrowers were hesitant to borrow because of their debt service capacity reducing the cost of borrowing to zero helped get people off the sidelines. Secondly, the Fed aggressively began to grow its balance sheet. This meant that the Fed was purchasing securities in the open market to provide liquidity to investors and boost the overall money supply when conditions were weak. These actions were important in helping the economy and markets recover in the time since the crisis.
Fast forward 10 years.
Despite forward-looking fears, the current state of the economy is incredibly robust. The unemployment rate is at an all-time low while the labor force participation rate has also been steadily increasing. Additionally, inflation appears to remain under control for the time being. Interest rates have risen but remain at historically low levels.
So, what is the Fed doing now?
Since the crisis very gradually the Fed has increased the fed funds target rate to maintain manageable inflation during continued growth. Additionally, they have gradually began to release the securities that they had held on their balance sheet to control the overall money supply in the economy.
The ‘hotly debated’ topic that we talked about earlier has to do with the potential unintended outcomes of fed policy decisions. Of the two mechanisms – moving rates and altering the balance sheet – the economy and markets are much more sensitive to changing rates than it is of changes in the money supply. If the Fed decides to raise rates too quickly they run the risk of hindering the economic growth and possibly causing market backlash. Conversely, if they don’t continue to return to a true neutral rate at some point there are other consequences. Additionally, if the economy takes another turn for the worse they won’t have much room to lower lending costs and spur borrowing like they did following the financial crisis.
Dovish v. Hawkish refers to the language used to reflect the stance of the Federal Reserve. Dovish means that they intend to pursue, in our case neutral, or expansionary monetary policy i.e. not raising rates and continuing to hold or buy open market securities. Hawkish is the opposite, they see the economy as able to support a more contractionary monetary policy stance i.e. higher rates and less money supply.
The Fed, hopefully, makes these decisions based off tremendous amounts of data received on a monthly, weekly, and even daily basis that ideally help monitor the health of the overall economy. The worry during 2018, that remains today, is that the Fed would consider rate hikes without truly listening to the data and seeing how the economy would react. The result of the Fed meeting minutes shows that, again, hopefully, the Fed has since changed its stance and is truly acting in a data-dependent way. In our present case being data-dependent has caused the Fed to have a more Dovish tone. There remains a lot of uncertainty for the remainder of 2019 and beyond. However, the information that we received is encouraging that the Fed is acting in a reasonable manner at a time when there is continual increases in volatility and uncertainty about the direction of the market and the broader economy.
To better understand how these risks may affect your portfolio, and in turn your overall financial well-being, it is important to consult with your financial advisor. Speaking with a financial professional is the best way to sort through what information is credible as well as relevant to you. In addition, understanding the bigger picture can help you make more informed decisions regarding your portfolio. You may even find that some of your long-term objectives may have shifted because of these shifting economic conditions.
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.
February 26, 2019
How the Fed's Changing Tone Might Affect the Economy
Since the beginning of 2019 the financial markets have continued to exhibit the heightened volatility that began in early 2018. This volatility follows an unprecedented five-year stretch of historically-low levels for the VIX. The VIX is CBOE’s volatility index — widely regarded as the ‘fear gauge’ for the overall market. We have also witnessed one of the greatest January rallies on record as stocks bounced from recent lows made during a tumultuous December of 2018. Looking at the year ahead, there are multiple headwinds that face the markets for the remainder of 2019 and beyond. Among the most notable risks; are fears of slowing global growth, trade skirmish concerns with China, uncertainty with the stance of the US Federal Reserve bank, and the geopolitical risks that face the U.S. With all of that being said here is a recap of the FOMC (Federal Open Market Committee) January meeting minutes that were released yesterday, and how that might affect your wealth.
Whether or not the Fed will hike rates in 2019 remains a hotly debated topic across all of Wall Street even after the minutes from the January’s meeting were released yesterday. Following comments from the January meeting there is indications that the Fed will hold off on additional rate hikes for now and instead tweak its other lever for controlling monetary policy: the balance sheet. In the second half of 2019, the Fed may look to stop unwinding and begin normalizing. Many have already pointed to this potential next step as a reflection of a more “dovish”. The Fed, by making the decision to influence monetary policy through balance sheet operations and just listen for the time being, is claiming to act in a more data-dependent manner than they had indicated during different points of 2018. It was a widely agreed-upon decision by the Fed to inform the public about their intention to end the runoff at this time, hoping to put to rest some of the uncertainty that has affected the market.
Let’s take a brief pause…
“Dovish”
“Data-dependent”
“Balance sheet normalization”
What does all of this mean?
There are two spheres of influence that the US Government conducts that affect the United States economy. The first is Fiscal Policy. This entails spending/allocation and tax decisions that are the result of legislative action taken by Congress. The second is Monetary Policy, and this is regulating the cost of borrowing money and the money supply in the economy to control inflation, promote overall economic stability, and maintain robust employment levels.
The Federal Reserve is an independently-operated government entity that controls the U.S. Banking System, and through the FOMC, controls monetary policy in the United States. There are two main mechanisms that the Federal Reserve uses to control monetary policy in the US, the target Federal Funds Rate as well as manipulating the balance sheet.
To understand how the Fed will act to help the economy through its influence on the banking system, we will us the Financial Crisis as an example due to it being the most recent and most tied to current conditions.
The Fed, by making the decision to influence monetary policy through balance sheet operations and just listen for the time being, is claiming to act in a more data-dependent manner than they had indicated during different points of 2018.
When the events of the Financial Crisis of 2008 transpired there was a widespread of fear and unrest within markets and the broader economy. Firms and individuals were hesitant to deploy any capital that remained because of the general uncertainty that surrounded some of the institutions previously considered incredibly stable. The Fed enacted expansionary Monetary Policy of epic proportions to stimulate the economy. First off, they cut interest rates to zero — nominal rates remained at zero until 2015. At a time when lenders were weary to lend because of credit risk, and borrowers were hesitant to borrow because of their debt service capacity reducing the cost of borrowing to zero helped get people off the sidelines. Secondly, the Fed aggressively began to grow its balance sheet. This meant that the Fed was purchasing securities in the open market to provide liquidity to investors and boost the overall money supply when conditions were weak. These actions were important in helping the economy and markets recover in the time since the crisis.
Fast forward 10 years.
Despite forward-looking fears, the current state of the economy is incredibly robust. The unemployment rate is at an all-time low while the labor force participation rate has also been steadily increasing. Additionally, inflation appears to remain under control for the time being. Interest rates have risen but remain at historically low levels.
So, what is the Fed doing now?
Since the crisis very gradually the Fed has increased the fed funds target rate to maintain manageable inflation during continued growth. Additionally, they have gradually began to release the securities that they had held on their balance sheet to control the overall money supply in the economy.
The ‘hotly debated’ topic that we talked about earlier has to do with the potential unintended outcomes of fed policy decisions. Of the two mechanisms – moving rates and altering the balance sheet – the economy and markets are much more sensitive to changing rates than it is of changes in the money supply. If the Fed decides to raise rates too quickly they run the risk of hindering the economic growth and possibly causing market backlash. Conversely, if they don’t continue to return to a true neutral rate at some point there are other consequences. Additionally, if the economy takes another turn for the worse they won’t have much room to lower lending costs and spur borrowing like they did following the financial crisis.
Dovish v. Hawkish refers to the language used to reflect the stance of the Federal Reserve. Dovish means that they intend to pursue, in our case neutral, or expansionary monetary policy i.e. not raising rates and continuing to hold or buy open market securities. Hawkish is the opposite, they see the economy as able to support a more contractionary monetary policy stance i.e. higher rates and less money supply.
The Fed, hopefully, makes these decisions based off tremendous amounts of data received on a monthly, weekly, and even daily basis that ideally help monitor the health of the overall economy. The worry during 2018, that remains today, is that the Fed would consider rate hikes without truly listening to the data and seeing how the economy would react. The result of the Fed meeting minutes shows that, again, hopefully, the Fed has since changed its stance and is truly acting in a data-dependent way. In our present case being data-dependent has caused the Fed to have a more Dovish tone. There remains a lot of uncertainty for the remainder of 2019 and beyond. However, the information that we received is encouraging that the Fed is acting in a reasonable manner at a time when there is continual increases in volatility and uncertainty about the direction of the market and the broader economy.
To better understand how these risks may affect your portfolio, and in turn your overall financial well-being, it is important to consult with your financial advisor. Speaking with a financial professional is the best way to sort through what information is credible as well as relevant to you. In addition, understanding the bigger picture can help you make more informed decisions regarding your portfolio. You may even find that some of your long-term objectives may have shifted because of these shifting economic conditions.
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.