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The Fed Approach

With the effective fed funds rate now only slightly below the range of estimates for neutral monetary policy and few signs of economic or financial market overheating, investors believe that the Federal Reserve is likely to hold rates steady in March, interrupting its pattern of quarterly interest rate hikes.

Against this backdrop, U.S. Treasury bond markets have recently started to price in a higher probability that the Fed will cut its policy rate in late 2019 or 2020. While the downside risks to the outlook have increased over recent months, investors believe it’s too early to forecast the next easing cycle with a high degree of certainty. Slowing global growth and tighter financial conditions over the last several months have negated the need for restrictive monetary policy, but don’t yet argue for rate cuts. Indeed, a prolonged period where interest rates remain at or close to current levels is very possible.

After modest downgrades to their growth and inflation forecasts at the December Federal Open Market Committee (FOMC) meeting, Fed officials will likely need to again downgrade their 2019 growth expectations and revise lower their forecasts for the appropriate policy path when the Fed’s updated Summary of Economic Projections is released in March. It is estimate that the cumulative tightening in financial conditions since the December FOMC meeting, if sustained, will slow U.S. economic growth in 2019, reducing the need for the Fed to tighten monetary policy to avoid overheating.

Still, it’s important to keep in mind that the magnitude of the recent tightening hasn’t been enough to warrant an outright easing in monetary policy, and absent a further deterioration in global economic fundamentals, investors do not think a recession in the U.S. is imminent.

Despite the recent turmoil in financial markets, significant sectors of the U.S. economy remain healthy. After deleveraging in the wake of the 2008 financial crisis, household balance sheets remain robust, and savings rates are high. Consumption, which makes up a sizable portion of U.S. GDP, continues to be supported by tight labor markets, lower energy prices and the recent tax cuts. Furthermore, post-financial-crisis regulations have strengthened the U.S. banking sector, which should mitigate the risk that contagion exacerbates an economic slowdown. Speculators think the financial sector demonstrated its broad stability and its ability to act as a buffer against shocks in 2014‒2015 when credit dislocations after the global energy price collapse did not materially spill over into other markets.

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