FEDERAL RESERVE OUTLOOK FOR 2020 - Western Asset
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January 2020
POLICY MATTERS
TOPIC OF FOCUS: ECONOMY
FEDERAL RESERVE OUTLOOK FOR 2020
On the Web: https://wam.gt/3006QKD
The Fed defied nearly all expectations in 2019 when it cut rates three times, shaving 75 bps off the fed funds
rate. Early last year, Western Asset had suspected the Fed might increase its focus on inflation, which would even-
tually require easier monetary policy. The Fed’s inflation focus became more apparent as the year went on, clar-
ified by both its actions and comments. The Fed’s inflation focus now implies a high bar for rate hikes in 2020.
Conversely, further cuts this year cannot be ruled out entirely if inflation continues to undershoot the Fed’s target.
KEY TAKEAWAYS
The 2019 rate cuts demonstrate that inflation now plays a much larger role in the Fed’s
monetary policy decisions than it has in the past.
The change in the Fed’s inflation outlook, in our view, was the primary motivator for the
Fed to cut rates in 2019.
It remains to be seen whether the Fed cuts are enough to sustainably boost inflation,
however, and for the moment we doubt that they are.
Our outlook for inflation to remain below 2%, together with the very high bar set by Chair
John L. Bellows, PhD
Portfolio Manager Powell, suggests that the Fed is unlikely to raise rates in 2020.
If the Fed is truly committed to boosting inflation, further rate cuts cannot be entirely
ruled out for 2020.
© Western Asset Management Company, LLC 2020. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients, consultants, and other intended
recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or
medium without express written permission.POLICY MATTERS
FEDERAL RESERVE OUTLOOK FOR 2020
John L. Bellows, PhD
The Federal Reserve (Fed) surprised almost everyone in 2019. It cut rates three successive times—July, September
and October—in an environment of reasonably stable US economic growth, a falling unemployment rate and
steady to rising risk markets.
The Fed’s willingness to cut rates in such an environment represented a distinct break from the previous two de-
cades of monetary policy, in which the Fed primarily took its cues from either the labor market or the stock market.
Investors who were slow to update their model of Fed behavior—and who, as a consequence, were expecting
the Fed to tighten or at best remain on hold in the face of rising stocks and a lower unemployment rate—found
themselves a step behind in 2019. Fortunately, Western Asset was not among that group.
Over the course of 2019 we argued that there was an ongoing shift in the Fed’s attitude toward inflation, which
would likely lead it to easier policy at some point. While the Western Asset view was controversial at the beginning
of the year, the contours of the Fed’s shift have subsequently become clearer and clearer. In particular, its rate cuts
have served as a tangible validation of our view. If there was an error in our analysis, it was that we didn’t take it far
enough. We harbored some lingering doubts about whether the Fed had truly changed its stripes, and therefore
we were a bit too timid in forecasting the amount of rate cuts. Yet the rate cuts came and then kept coming, even
as growth and markets held steady.
The Fed’s rate cuts last year have implications for the 2020 outlook. First, the 2019 rate cuts demonstrate that infla-
tion now plays a much larger role in the Fed’s monetary policy decisions than it has in the past. Second, the focus
on low inflation has moved the Fed toward a “make-up” strategy, whereby the Fed would seek to offset periods
of below 2% inflation with periods of above 2% inflation. Any such “make-up” strategy implies the bar for future
hikes has been set quite high. Finally, in 2019 the Fed showed it is willing to back its inflation objective with policy
actions. Fed Chair Jerome Powell has insisted that willingness remains in place. This means a further easing of policy
cannot be ruled out, and would become increasingly likely if inflation failed to rise in line with Fed expectations.
Inflation in Focus
Our view is that the rate cuts of 2019 were first and foremost about inflation. Other explanations were offered
at the time and have continued to be promoted since, including “insurance cuts” and as a response to a global
“Our view is that
economic slowdown. These other explanations are unconvincing, in our view, as they neither fit the fact pattern
the rate cuts of nor do they answer the question of what compelled the Fed to act in excess of almost everybody’s expectations.
2019 were first and
The analogy between 2019 and the “insurance cuts” of 1998 seems particularly unhelpful. It’s true there are sim-
foremost about ilarities. For example, the Fed cut the same amount in both years (0.75%) and there were fears surrounding an
inflation.” emerging market economy in both years (Russia in 1998, China in 2019). But these similarities are overshadowed
by the differences. One significant difference is that in 1998 the Fed was responding to what was, at the time, a
widespread and growing concern about financial markets in general, and the vulnerabilities of levered investors
in particular. By the time the Fed first cut rates in September 1998, the S&P 500 had declined 10% from its peak
and huge losses had forced Long Term Capital Management to shut down. Needless to say no equivalent financial
market stress was seen in 2019, as in fact the S&P was higher at the time of the Fed’s July cut than it was at the
time of the Fed’s last hike.
Western Asset 1 January 2020POLICY MATTERS
Rather than “insurance cuts,” the most obvious explanation for the Fed’s rate cuts in 2019 was a focus on inflation,
and in particular a renewed concern about below-target inflation. In contrast to 2018, when the inflation outlook
was favorable and the Fed was hiking accordingly, the inflation data in 2019 was disappointing pretty much across
the board. Of particular note was the plateauing and slight deceleration of wage inflation (Exhibit 1). While wage
inflation is not explicitly included in the Fed’s mandate, it carries elevated significance because of its salience for
workers and its more immediate connection to the full employment part of the Fed’s mandate. Also of note was
the decline in inflation expectations, for example, as measured by TIPS breakeven inflation, which ended the year
“In contrast to suggesting that future inflation would remain decidedly below the Fed’s 2% objective (Exhibit 2). Finally, the
2018, when the Fed’s preferred inflation measure, core personal consumption expenditures (PCE), moved lower in 2019 due to a
combination of idiosyncratic events as well as ongoing softness in services inflation. Taken together, the stall in
inflation outlook
wage inflation, the notable decline in inflation expectations and the below-mandate prints for core PCE suggest
was favorable a much more troubled outlook for future inflation than the Fed maintained previously. This change in inflation
and the Fed was outlook, in our view, was the primary motivator for the Fed to cut rates in 2019.
hiking accordingly,
Obviously the link between inflation and the 2019 rate cuts is clearer with the benefit of hindsight. Over the course
the inflation of the year, Fed officials themselves gave a series of muddled explanations for their actions, often finding it conve-
data in 2019 was
disappointing Exhibit 1: Wage Inflation
pretty much across Employment Cost Index Average Hourly Earnings
5.0
the board.”
4.5
Percent Change, Year Over Year
4.0
3.5
3.0
2.5
2.0
1.5
1.0
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019
Source: Bureau of Labor Statistics, Haver, Bloomberg, New York Federal Reserve. As of 31 Dec 19
Exhibit 2: Inflation Expectations
Univ. of Michigan (5Y Ahead) New York Fed (3Y Ahead) TIPS Breakevens (5Y5Y), Right Axis
3.50 3.50
3.25 3.25
3.00
3.00
2.75
2.75 2.50
Percent
Percent
2.50 2.25
2.25 2.00
1.75
2.00
1.50
1.75 1.25
1.50 1.00
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
Source: Bureau of Labor Statistics, Haver, Bloomberg, New York Federal Reserve. As of 31 Dec 19
Western Asset 2 January 2020POLICY MATTERS
nient to cite multiple rationales at the same time. However, by the final rate cut in October the other reasons had
declined in importance and all that was really left was a heightened concern about low inflation. At that meeting
the Fed admitted that the uncertainty about global events had receded and that US growth continued to be rather
sturdy, yet the Fed cut rates anyway. In his last press conference of 2019, Chair Powell returned again and again to
the subject of low inflation, highlighting in a variety of contexts how low inflation had influenced the decision to
cut rates. Here are a few examples of Powell’s emphasis on inflation from that press conference¹:
“As you can see, inflation is barely moving up, notwithstanding that unemployment is at 50-year lows and
expected to remain there … In fact, we need some upward pressure on inflation to get back to 2 percent.”
“We believe that policy is somewhat accommodative, and we think that that’s the appropriate place for
policy to be in order to drive up inflation.”
“That underscores, I think, the challenge of getting inflation to move up. The Committee has wanted inflation
to be at 2 percent, squarely at 2 percent, for—ever since I arrived in 2012. And it hasn’t happened, and it’s
just—it’s because there are disinflationary forces around the world, and they’ve been stronger than, I think,
people understood them to be.”
Powell’s message was unmistakable: low inflation was the key to understanding the Fed’s actions in 2019. In our
“Powell’s message view, it’s likely to also be the key going forward as well.
was unmistakable: High Bar for Future Rate Hikes
low inflation was “So I think we would need to see a really significant move up in inflation that’s persistent before we would
consider raising rates to address inflation concerns.” – Chair Powell, October 2019
the key to under-
standing the Fed’s Not only did the concern about low inflation play a significant role in motivating cuts in 2019, but it also appears to
actions in 2019.” have shaped how the Fed intends to conduct policy going forward. In particular, a number of Fed speakers have
mentioned the desirability of a “make-up” strategy with regard to inflation, whereby periods of inflation below
2% would be offset by periods of inflation above 2%. The details of such a strategy are still being debated, and it
could take a few months for the specifics to be announced as official Fed policy.
It would be a mistake, however, to wait for the official announcement to incorporate this into the outlook. Indeed,
based on his recent comments, it appears Chair Powell has already embraced a “make-up” strategy. In each of
the last two press conferences Chair Powell has said that in order to raise rates he would need to see “a really
significant move up in inflation that’s persistent.” Given the starting point of the Fed’s preferred inflation measure
(core PCE at 1.6%), it seems fair to conclude that a “really significant move up” would take inflation above 2%. It
also seems fair to interpret Powell’s inclusion of “persistent” in the criteria as a response to the extended period
of below-target inflation. Powell’s guidance, which he has now repeated twice in response to direct questions,
is therefore essentially to adopt a make-up strategy.
The important conclusion is that Powell’s make-up strategy sets the bar for future rate hikes exceptionally high. To
put this into perspective, consider the following back-of-the-envelope calculation. Based on Powell’s comments, it
seems reasonable to assume that core PCE would need to be 2.2% or higher for at least six months to justify a rate
increase. (These assumptions are made to be consistent with Powell’s “really significant” and “persistent” criteria.
But the point here is a general one and the conclusion would likely hold under whatever final formulation the Fed
arrives at for its make-up strategy.) Further, note that the annual volatility of core PCE over the last 20 years has
been 0.6%. Based on these assumptions and the historical volatility of inflation, there is a less than 7.5% chance
that Powell’s criteria would be satisfied by the end of 2020 (Exhibit 3).
Western Asset 3 January 2020POLICY MATTERS
Exhibit 3: Core PCE Volatility
+/– 1 Std Dev +/– 2 Std Devs "Make-up" Strategy Target (2.2%)
3.50
+2 Std Dev (3% Probability)
3.00
2.50 +1 Std Dev (16% Probability)
Percent 2.00
1.50
1.00
0.50
0.00
Dec 19 Mar 20 Jun 20 Sep 20 Dec 20 Mar 21 Jun 21
Source: Bureau of Economic Analysis, Western Asset. As of 31 Dec 19
Three caveats are warranted for this rough calculation. First, Powell was careful to qualify his criteria by saying that
it has not yet been made into official forward guidance. Official codification could happen when the Fed finishes
its ongoing strategy review—and in our view it likely will happen when the review is finalized—but until then
there is some risk of back-tracking. Second, the Fed could theoretically be motivated to increase rates for some
reason other than inflation, potentially to address financial stability concerns. That said, the risk here seems rather
small at the moment, especially as there are other tools the Fed could deploy if financial stability concerns were
to mount much further (for example, the counter-cyclical capital buffer). Finally, this analysis does not incorporate
an inflation forecast, but instead simply reflects historical volatility of inflation. Incorporating an inflation forecast
would obviously affect these probabilities. This is the topic we address in the next section.
What If Inflation Doesn’t Rise?
“Our view at Our back-of-the-envelope calculation was based on only the historical volatility of inflation. Accordingly, it did not
incorporate a forecast of inflation. Our view at Western Asset is that inflation is unlikely to rise above 2% in the near
Western Asset is future. As we discussed in a paper last year, Falling Inflation Could Move the Fed, neither the bottom-up nor the top-
that inflation is down analysis of inflation indicates a strong case for an acceleration. The Fed’s actions since that paper was written
unlikely to rise make the top-down case for an inflation acceleration slightly stronger at the margin. It remains to be seen whether
the Fed cuts are enough, however, and for the moment we doubt that they are. The global disinflationary headwinds
above 2% in the remain firmly in place, and the bottom-up analysis doesn’t suggest much has changed.
near future.”
Our outlook for inflation to remain below 2%, together with the very high bar set by Chair Powell, suggests that the
Fed is unlikely to raise rates in 2020. In particular, given our low inflation outlook, the probability of a rate increase
due to inflation appears to be even less than the 7.5% calculated in the previous section. What makes this conclu-
sion all the more notable is that there is a healthy margin of safety in our analysis. Even if inflation were to move up
somewhat, and even if it were to exceed our expectations and reach 2% next year, that would still be insufficient
to generate a Fed response.
A trickier question is whether another year of below 2% inflation could motivate the Fed to continue cutting rates. In
other words, could 2020 see a repeat of 2019 in terms of Fed cuts? There are reasons to doubt the Fed’s willingness
to continue cutting, including the US election cycle and a much-discussed split of views within the Fed. In addition,
the outlook for growth and risk markets has turned up recently, due in part to reduced political and trade risks. It’s
hard for the Fed to cut into a brightening growth outlook.
Western Asset 4 January 2020POLICY MATTERS
Yet, many of those same claims could have been made at various points in 2019, and the Fed cut rates anyway.
The experience of 2019 showed that the Fed is indeed capable of acting to support inflation, and is also capable
of overcoming the common objections to doing so. Chair Powell has insisted that the Fed remains committed to
boosting inflation. He has further said that the Fed’s commitment extends beyond words and will result in actions
when needed. Therefore, it seems unadvisable to fully rule out further rate cuts. While not quite the base case, if the
Fed is truly committed to boosting inflation, it may turn out that the Fed is compelled to cut again sometime in 2020.
Conclusion
“Going forward, As we reflect on what changed in 2019 we are struck first by the number of things that did not change. The eco-
nomic recovery remains ongoing, although unspectacular in magnitude. The policy backdrop remains challenging,
the Fed’s new although arguably not any more so than at the beginning of the year, especially with regard to trade policy, where
focus on inflation there has been some recent relief. And inflation remains very subdued both in the US and around the world.
implies a high bar,
What does appear to have changed, however, is the Fed’s willingness to act to support inflation. The Fed’s three
and therefore low cuts in 2019 surprised anybody who expected monetary policy to be determined primarily by the unemployment
probability, for rate or by risk markets. Such a view may have been understandable—after all, it had accurately described the Fed’s
behavior for the prior two decades—but it was worse than inaccurate in 2019.
future hikes.”
In contrast to many investors, Western Asset was positioned on the correct side of the Fed outlook in 2019 because
we recognized early on that the Fed had adopted a new focus on inflation. Going forward, the Fed’s new focus
on inflation implies a high bar, and therefore low probability, for future hikes. Chair Powell made this clear when
he said his criteria for rate hikes is “a really significant move up” in inflation that is “persistent.” Finally, a new focus
on inflation means that further cuts cannot entirely be ruled out, especially if inflation continues to challenge the
Fed by remaining below 2%.
ENDNOTES
1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20191211.pdf
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