US Economy 2Q19: Gradualism back in play

The US central bank has made clear that the pace of balance sheet normalisation will be slowed
Chief Investment Office16 Apr 2019
Photo credit: AFP Photo

The Fed cements its dovish tilt. Conventional wisdom in the markets used to be “don’t fight the Fed”. However, over the past decade or so, the US central bank has repeatedly scaled back its expectations of growth and inflation, and displayed acute sensitivity to the performance of asset markets. Perhaps the Fed now believes “don’t fight the markets”.

The 20 March FOMC decision reveals a bit more dovish view of the growth and inflation outlook, but these are not that material. After all, the economic projections are only 0.2% lower (2.1% vs. 2.3% made in December) and even more modest for inflation (1.8% vs. 1.9%). But between the line, we are picking up a more profound signal – which is that despite strong wage growth and rebounding commodity prices, the Fed will take a relaxed attitude if inflation were to pick up again. If true, this would mark a major departure in the monetary policy stance. We think that Fed communication will be increasingly focused on this area; having undershot its inflation target year after year, a bit of overshoot will be overlooked by the Fed in 2019 and 2020.

The implication of this line of signalling could be substantial. Right now, the fixed income market is rallying, but could the long-end eventually sell off as inflation bottoms, fiscal deficit remains large, and demand for long-duration assets wane? We think this is quite possible, and not at all priced by the market.

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