The 4 Factors That Determine the Fed's Next Steps

(Bloomberg Opinion) -- The dramatic change in the Federal Reserve’s qualitative signals, along with slowing global growth, has opened the way for other central banks (including Australia’s and India’s) to adopt more dovish policies, even though interest rates in most countries are already at historically low levels.

The question now is not whether and when the Fed will change its official quantitative policy guidance, but how much it will do so as it moves away from the current path of two rate hikes in 2019 to a new baseline of no hikes in 2019 and a balance of risk toward a rate cut in 2020. It would act for the following four reasons, even though the U.S. will likely continue to show solid growth and outpace other advanced economies.

1. Growth divergence:  As illustrated by what came out of from the recent World Economic Forum in Davos, Switzerland, the global economic and corporate consensus has shifted markedly toward the worrisome concept of a synchronized slowdown, after an excessive embrace last year of the notion of a synchronized pick up in global growth. Yet such a slowdown is not the most likely outcome for 2019. Rather, the world – and advanced economies in particular – faces a period of growth divergence among the three biggest regions: Europe, China and the U.S.
   Slowing economic activity in Europe, together with a pronounced shift in the balance of risks toward more downside, will force forecasters to cut their growth expectations, which the European Commission and the Bank of England already did last week.
   The European Commission revised downward its 2019 projection for the euro zone by a meaningful 0.6 percentage points, with reductions for most countries, including the four largest – France, Germany, Italy and Spain. Yet areas of emerging and deepening weakness around the continent suggest that further cuts are forthcoming, with the most likely outcome being an overall growth rate below 1 percent and recession in more fragile economies such as Italy.
   The Bank of England, meanwhile, cut its growth rate for 2019 to 1.2 percent, which would be the slowest annual expansion of the last 10 years. Citing evidence of weakening investments and consumption due to heightened economic uncertainty, Governor Mark Carney warned that the “fog of Brexit” is expected to further dampen sentiment, with an even bigger downside risk in the short term if the U.K. makes a disorderly exit from the European Union.
   In China, the falling purchasing manager indexes continue to illustrate the authorities’ growing policy dilemma. Old-style measures, such as cuts in reserve requirements and greater directed lending, have become both less effective in stimulating growth and more likely to accentuate financial distortions and resource misallocations. But the short-term difficulties of a more forceful pivot to more forward-looking structural reforms increase in the context of lower growth.
   All of this contrasts vividly with the U.S. situation. The jobs report for January confirmed the continued strength of the labor market, the most important driver of consumption and growth. Last month, employment creation continued the trend of outcomes that are consistently and significantly stronger than consensus expectations. Also, the annual growth in wages remained above 3 percent. At the same time, corporate investment activities are underpinned by solid earnings, which also illustrates the extent to which companies have been able to navigate the more challenging international environment.
   Absent another government shutdown or some other policy slippage, such as another Fed miscommunication, U.S. growth should remain robust. Indeed, the expected economic performance on a standalone basis would warrant Fed rate hikes rather than my baseline scenario. But the central bank will (and should) be sensitive to the risk of spillback from weakness abroad, a consideration that will be amplified by the three factors below. 
2. Evidence of slack and the productivity potential: In addition to the encouraging pace of employment creation, the last jobs report supplied the Fed with indications of remaining slack in the labor market. The direct evidence came in the form of a further pickup in labor-force participation, which illustrated the potential for more people re-entering the labor market. Further proof was provided by the relatively stable wage-growth number that prevails notwithstanding the JOLTS and jobless claims data that would suggest otherwise. You can add to that signs of a productivity pick up after years of unusually low growth.
3. Muted inflation: Don’t look for the recent years of significant liquidity injections by central banks and very low interest rates to result in any worrisome short-term spike in prices that necessitates further rate hikes. Deepening structural changes to the way economic activity is undertaken, including a significant shift to the responsiveness of supply, will continue to act as an overall dampener for inflationary pressures. Neither should we expect, as a baseline projection, a commodity price shock, also because of the improved management of inventories and the availability of alternative supplies in certain areas (such as oil).
4. Market codependence: The market turmoil of the fourth quarter of last year reminded the Fed that investor perceptions of an inadequately sensitive policy stance can ignite technical asset-price dislocations and increase the risk of contaminating the real economy. The consequences go beyond last month’s dramatic pivot at the FOMC meeting in favor of patience on rate hikes and flexibility on balance sheet reduction.
   The Fed under Chair Jerome Powell, as well as under his two immediate predecessors, is unlikely to show a strong appetite for diverging much from market expectations – even though some officials may still feel the need to do so to build up greater policy flexibility in the event of a future economic slowdown, and to reduce the risk of larger financial market volatility down the road.

In technical terms, these four factors reinforce the notion that the Fed is near or within the range of the economy's neutral rate of interest, or r*. And even if that's not true in actuality, it will be part of the Fed’s perception for now.

So look for the Fed's blue dots to migrate in March significantly away from the current signal for rate hikes in both 2019 and 2020, though they won't yet point to a rate cut next year. That would come later as Europe and China continue to struggle in pivoting to more effective pro-growth policy stances – unless, contrary to my baseline expectations, the U.S. reverts to self-inflicted economic wounds or fails to convince China to make meaningful concessions on trade. In that case, it could well come earlier.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”

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