Although economic fundamentals are favorable, volatility continues to affect markets. Does the Fed’s latest rhetoric signal a near-term pause in rate hikes?
Concerns about the health of the global economy have re-emerged, as investors face elevated volatility in markets. This persistent volatility—and its impact on tightening financial conditions—tend to focus market attention on the central banks. Investors then go on high alert, looking for any indication of coming policy changes to soothe market anxieties.
In commentary from early November, Federal Reserve Chair Jerome Powell and Vice-Chair Richard Clarida sent a consistent message: the Fed is data-dependent, but since the U.S. economy continues to do well, they still anticipate a gradual path of raising interest rates into 2019.
While a course change remains unlikely, my colleagues and I at Morgan Stanley Research sense a subtle shift in tone relative to a few weeks ago, putting more emphasis on data dependence and signaling some flexibility on policy management after reaching neutral.
The current economic backdrop sets a high bar for any change in policy. U.S. growth has been running above trend for a while; the unemployment rate has been running below its natural rate for the past 20 months; wage growth has accelerated, reaching a post-crisis high of 3.1% annually; inflation in core personal consumption expenditures has stayed at target for a couple of months; private nonresidential investment growth momentum has averaged roughly 6% annually for seven quarters; and productivity growth has picked up in the past two quarters.
Further, households are saving more of their income than in 2006-07 (6.2%, to be precise), and household debt-to-disposable income ratios have remained low and stable. With both the strength and character of this economic expansion looking this good, it would be hard to build a fundamental case that the Fed needs to change course quickly.
However, should the Fed worry about international developments? On the surface, recent growth data have weakened in Germany and Japan, while there are lingering concerns about the outlook for China and emerging markets in general.
However, for Germany and Japan, the outright contraction in economic activity in the third quarter was largely due to one-off factors, such as natural disasters in Japan and the impact of new emission standards on Germany’s auto industry. Moreover, survey data in both of these economies indicate that activity probably picked up in October, suggesting that the impact is temporary. As for China, defensive easing measures should help to stabilize growth in the next one or two quarters.
In short, the global growth backdrop does appear supportive. In aggregate, global growth, on our estimates, did decelerate to 3.4% in the third quarter, down from a very strong 4.1% in the second quarter. However, we estimate that it will move back above trend to 3.6% in the fourth quarter. The fading of temporary disruptions to growth in Germany and Japan, still-healthy momentum in global trade and a sustained recovery in emerging markets, excluding China, should all lend continuing support to global growth.
Given the domestic directive, it is our view that the Fed will only react to international developments if they affect the U.S. economic outlook, and likely won’t conduct policy in a way that pre-empts them.
With the global economy expected to grow around trend, our chief U.S. economist, Ellen Zentner, expects the Fed to keep raising interest rates until it believes it has reached “neutral territory”—where it is neither stimulating nor restricting economic growth—and then pause. In her view, that will happen around the middle of 2019, following three more hikes—in December, 2018, and March and June, 2019.
However, as central banks stay on a tightening path, the ride will likely be bumpy. Asset markets will hit pockets of stress from time to time, with the latest episode unfolding in U.S. credit markets. Our strategists remain cautious and think that the weakness in credit will continue. Indeed, we think that asset markets must leave the warm embrace of the abundant liquidity that central banks have provided since the global financial crisis. Like it or not, volatility is here to stay.