Over the years I have heard many different sources, from economics professors to Fed Chairmen, say that the Federal Reserve doesn’t pay attention to the stock market when it comes to deciding rate policy. I think we all know better than that.
When the Fed stepped in and started lowering rates at the end of 2007, you can bet that the stock market volatility was one of the reasons. Yes the credit markets were tightening and that was one of the biggest reasons, but seeing some steep losses in the stock market certainly played a role as well.
If you look back to the bear market and economic slowdown from 2000 to 2002, you see the same thing happening. The Fed started lowering interest rates in early 2001, and the Fed Funds rate fell from 6.5% to 1% from December 2000 through July 2003. If you look back at the GDP numbers during that time period, there were only two quarters where the growth rate was negative. How do you justify that kind of cut in interest rates with only two quarters of economic slowing? If they weren’t making the decision based on the stock market, what were they basing it on?
The dual mandate of the Fed is to maintain maximum employment and stable prices. In 2000, the unemployment rate was below 4.5% throughout 2000 and through the first half of 2001. It didn’t move above the 5.5% level until late 2001, and that was after the attacks of September 11. The Fed had already cut the Fed Funds rate to 2.5% at that point.
The GDP wasn’t in negative territory and unemployment wasn’t terribly high, but the Fed had cut the Fed Funds rate by 4%. Was it because inflation was out of control? No, the inflation rate was consistent throughout 2000 with every reading being between 3.2% and 3.8%. In May 2001, the inflation rate was at 3.7% and then it started falling sharply. It dropped to 2.7% by August and then after September 11, it fell all the way down to 1.2%.
Inflation wasn’t an issue, GDP wasn’t really an issue except in two quarters, and the labor market wasn’t an issue. Why was the Fed lowering the Fed Funds rate so sharply and so quickly? I think you get my point by now. The Fed was paying attention to the stock market.
Jumping ahead to the present, in the last few weeks we have heard a different tone from various Fed members. The course of rate hikes seems far less certain now than it was a month or so ago. The unemployment rate hasn’t changed much and the inflation rate hasn’t changed.
But many people are questioning whether we will see rate hikes at all in 2019. I even read one article from Yahoo Finance that was speculating whether the Fed would do another bump to interest rates next week.
Looking at the probability calculations from the CME Group, we see that the market has the futures priced at a 75% probability of the rate being hiked by 0.25% and a 25% chance of the rate staying the same. At the bottom of the image you can see that one week ago the probability was at 84.4% for a hike.
What message would it send to the market if the Fed didn’t make the expected rate hike? Would investors take this as a bad sign that the Fed sees things getting worse before they get better?
Looking ahead into 2019, the probabilities for the March Fed meeting show a 60% probability of a target rate of 2.25-2.5% and a 22% chance of a target rate of 2.5-2.75%. Just one month ago, the probability of the target rate being 2.5-2.75% was at 50%. This shows you how traders and analyst are predicting the next moves by the Fed.
One noted investor weighed in on Monday and said he doesn’t think the Fed will hike rates in 2019. Paul Tudor Jones stated on CNBC that, “The one thing I would say is there’s a high probability that this hike, assuming they hike, will be the last one for a long time.”
Personally, I think the Fed goes ahead with the rate hike next week and then plays a waiting game. They will wait to see what happens with the stock market, with the trade war, with the yield curve… Those factors are going to change in the next few months and once we see where the stock market is headed, what happens with the trade war, and what happens with the yield curve—the Fed will have a better idea on what actions are needed.