2019: A TRANSFORMATIONAL YEAR?


To appreciate why 2019 may become a transformational year, one needs to carefully examine the tremendous change in 2018.


The challenge in economics and markets is that many impacts occur with long and variable lags, and the indirect effects and unintended consequences often overwhelm the more easily measured direct effects. Consequently, it is likely that 2019 will look quite different from 2018. Current data is only beginning to reflect the critical changes, and economic data from the recent past is probably a very poor guide for what may happen in 2019 as the lagged effects kick in. Let’s examine some of the transitions currently in progress.


U.S. RATES The Federal Reserve (Fed) is on track for four rate rises in 2018 and its 8th rate hike in the past two years. By our measures, the Fed is very close to completing the policy shift from accommodative to neutral – meaning that interest rate policy is no longer encouraging economic growth, nor is it constraining growth. Since the concept of a neutral policy is a little fuzzy, the debate in 2019 will be about how high to take rates during this cycle.


One view is that the Fed might overtighten, as it has inadvertently in the past. Another view is that the rate hikes of 2017-2018 will work to decelerate economic growth in 2019, and that as the economy decelerates into 2019 with inflation staying relatively close to 2.5%, then a data-dependent Fed may halt its rate rises sooner rather than later.


Chart 1: US Effective Federal Funds Rate 4%


3% 2% 1% 0% Source: Bloomberg Professional (FEDL01)


What is clear from history is that there is a 4-stage pattern of the rate-employment cycle which has often been repeated.


(1) With low unemployment, the Fed worries about an overheating economy, raises short-term rates and flattens the yield curve.


(2) The policy shift leads to equity volatility and a jobs recession some 12-24 months after monetary accommodation has switched from accommodative to restrictive.


(3) With unemployment reaching higher levels, the Fed cuts rates, shifting back to an accommodative policy. And,


(4) the accommodative policy helps get the economy going and unemployment falls. Rinse and repeat. Thus, while a 2020 recession is not our base case, if the Fed decides to push rates ever higher in 2019, then a 2020 recession has a meaningful probability – maybe about 33%. Of course, the Fed is fully aware of this 4-stage rate-employment cycle, and it will be a center piece of the discussion in the Federal Open Market Committee (FOMC) meetings in 2019.


Where will the Fed Stop ? WHAT IS CLEAR FROM


HISTORY IS THAT THERE IS A 4-STAGE PATTERN OF THE RATE-EMPLOYMENT CYCLE WHICH HAS OFTEN BEEN REPEATED.


24 | ADMISI - The Ghost In The Machine | November/December 2018


Effective Federal Funds Rate


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