Economic Insights: The Fed and the Market

Roughly speaking, the put means that the Fed steps in to prop up the market when things head downward until economic conditions strengthen.

Anyone who hoped that relatively new Chairman Powell would abandon the “put” on the market that some of his predecessors had used surely found last week’s Fed minutes and interview disappointing. That group likely includes the chairman himself, who probably did not wish to resort to it either. But reading the minutes and interview with the chairman and noting how dovish the Fed has turned in such a short period of time leads us to conclude that the put remains alive and well.

Recall that in the fourth quarter of 2018 the equity markets entered correction territory while credit conditions tightened with spreads widening. The Fed sometimes steps in because of the risk that declining markets could impact real behaviors, namely via the wealth effect, the idea that consumption pulls back as consumers feel less wealthy.

Since the meeting in December, the Fed has wielded its newfound dovish credentials – in speeches, statements, presentations, panels, interviews, and now minutes. The charm offensive looks as if it’s in full force, including not just indications that fewer rate hikes will come this year, but also that slowing balance sheet normalization could also occur. The markets have responded. The equity markets recovered somewhat since a significant pullback on Christmas Eve and credit conditions have loosened a bit. To be fair, the Fed should not ignore the “crosscurrents” that they find concerning. Global economic growth is weakening; despite its end, the government shutdown reflects greater domestic political challenges; and financial conditions remain somewhat tighter.

We still forecast 1-2 rate hikes this year.

Given this dovish turn, we still forecast 1-2 rate hikes this year, but are leaning toward one and the timing of any hike looks more distant than it did just one month ago. For now, we do not foresee any changes to balance sheet normalization and expect a roll down of $50 billion per month.

Solid as a rock

Without parsing the semantics of Fed speeches and minutes, we believe that the economy remains solid. Domestic economic growth is slowing, but we predict expansion around 2.5 percent this year, which would rank among the best years of the current expansion. The ISM Manufacturing index rebounded in January signaling domestic momentum despite global issues. And the labor market data released last week reflects a firm footing. In January the economy created 304,000 net new jobs. This figure looks a bit exaggerated to us, not only because it sits significantly above trend but also because the response rate for the first reading seems low. Recent experience suggests remaining skeptical. For January’s report the response rate was 60.7 percent. Initially in December, the response rate clocked in at a similar 61 percent with a net jobs figure of 312,000. With January’s update, the response rate for December rose to 88.3 percent and the net job gain was revised down to 222,000. With demographic change alone producing roughly 150,000 net new entrants to the labor force, such a figure looks less spectacular.

With the economy still growing and roughly 7 million jobs remaining open but unfilled, we continue to foresee an acceleration of wage growth.

But more than the job figures, the wage data continues to firm up as we also predicted. With revisions, average wage growth on a year-over-year basis reached 3.3 percent during October, November, and December. The rate falls just 30 basis points below the high reached during the last business cycle. Year-over-year wage growth has reached at least 3 percent during the last six months (exceeding that threshold in five of those six months), the longest such streak since April 2009 when significant ongoing job losses distorted the data somewhat. On a real basis, wage growth has returned to levels seen during the last expansion. Supporting this, data from the employment cost index (ECI) showed that wages and salaries grew 3.1 percent year-over-year, the highest rate during the current expansion.

When doves cry

Against such an economic backdrop, it’s possible the Fed turned too dovish too quickly. While inflation remains tame, giving the Fed some margin for error, rising rates over the last two years have played an important role in keeping inflation in check. The Fed now looks likely to back off rate hikes until the latter half of the year. This puts the labor market in a key position because no other force is putting upward pressure on inflation and one of the key forces applying downward pressure has been removed, at least temporarily. We still believe that the Fed’s stance tends toward tightening than easing, but its quick about face makes it appear more market-dependent than data-dependent. Even though consumer confidence and sentiment have pulled back from recent highs, they remain elevated. And our research leads us to believe in a smaller and less dangerous wealth effect than many believe.

What we are watching this week

We expect that the ISM nonmanufacturing index for January changed little and should continue to signal ongoing expansion. Initial jobless claims jumped by a significant amount during the week ending January 23. While that figure was likely exaggerated by the government shutdown we continue looking at initial claims for any signs of slowing in the labor market. Lately, we have found few if any signs of labor market slowing and expect a pullback in initial claims for the week ending February 2.

What it means for CRE

For commercial real estate (CRE) the pause in rate hikes will provide time for the market to adjust to higher short-term rates. With the underlying economy remaining firm, CRE market fundamentals should fare well, even with the cycle past peak. The combination of relatively stable market fundamentals and interest rates could prop up enthusiasm for CRE investment, even if transaction volume declines relative to 2018’s surprise resurgence. Barring an abrupt change in policy, the environment for CRE looks favorable in 2019.

Thought of the week

Foreign revenues for S&P 500 companies totaled 43.6 percent in 2017, the most recent year available, down from 47.8 percent in 2014.

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