EUR/USD

The Federal Reserve has raised the fed funds target rate by another 25bp to a range of 2.25%-2.50%. The Committee, however, sounded more cautious about the outlook and pledged to “monitor global economic and financial developments”. The FOMC members’ median interest rate projections now only show two hikes for 2019 (down from three), while the estimate for the longer run natural rate was lowered to 2.75 from 3.00%.

Despite tighter financial conditions and growing political pressure, the Federal Reserve today delivered a unanimous 25bp rate hike. With this move, the Fed has lifted its target rate four times this year, for a total of 100bp. That is the largest annual increase in short-term rates since 2006. Strong economic growth, a falling jobless rate and inflation rates close to the 2% target allowed the Fed to gradually normalize its policy stance. It is important to remember, however, that even after those rate hikes, the target rate remains below most estimates for the equilibrium rate. In other words, the policy stance has remained accommodative.

The post-meeting statement contained only a few changes. But those that were made send the clear message that the FOMC’s confidence in the medium-term outlook has been rattled. First, it is now the Committees “judgment” rather than its “expectation” that “some further gradual increases in the target range for the federal funds rate will be consistent with” meeting the dual mandate. Second, it is now the Committee’s judgment that risks to the outlook are “roughly balanced”. Moreover, the statement qualified the balanced-risk assessment by adding that the Committee will “monitor global economic and financial developments and assess their implications for the economic outlook.”

At the very least, these wording shifts represent a weakening in the Fed’s forward guidance in favor of a more data-dependent approach. This is how it should be, in particular as rates have gotten closer to the neutral level, while at the same times headwinds are mounting.

The macroeconomic forecasts have not been changed by a lot, with the 0.2pp downward revision to 2019 GDP growth (from 2.5% to 2.3%) being the single-largest adjustments. The changes that were made, however, all point in the same direction: GDP growth a tad lower, the jobless rate a tad higher, and inflation a tad lower. This mirrors the declining confidence in the outlook amid growing uncertainties and mounting headwinds. In line with this – and consistent with Chair Powell’s recent comments made to the Economic Club of New York –, the FOMC members have lowered their interest rate projections. The median projections (the “dots”) now show only two hikes for 2019 (down from three), followed by one more hike in 2020. The resulting fed funds target rate for yearend 2019, 2020, and 2021 is thus 2.9%, 3.1% and 3.1%, respectively. At the same time, the estimate for the longer-run natural rate has been lowered to 2.8% from 3.0%. This implies that the Committee’s baseline scenario still looks to bring the fed funds target rate into a mildly restrictive are by the end of next year.

With the downward revision to the 2019 dot, Fed officials now project the same amount of rate hikes for next year as we do.

EU reached a deal with Italy

The European Commission reached a deal with Italy over the country's 2019 budget that avoids an EU disciplinary procedure against Rome, Commission Vice President Valdis Dombrovskis said. He added the decision could be revised in January if Rome did not fully apply the agreement reached with Brussels. Under the compromise, Italy has lowered its headline deficit for next year to 2.04% of output from 2.4% it had planned earlier.

The more important structural deficit, however, which excludes one-off items and business cycle swings, will not change in 2019 from 2018 levels. Under EU rules, Rome was supposed to reduce the structural deficit by 0.6% of GDP, but instead proposed in its original 2019 draft budget an increase of 1.2% according to the Commission. The compromise at zero change was not ideal, Dombrovskis said, but allowed the Commission to drop plans to start disciplinary action that could end up in fines.

Slowdown in UK CPI

British consumer prices rose at an annual rate of 2.3% in November, the lowest since March 2017, in line with market consensus and down from 2.4% in October.

The biggest monthly fall in petrol prices in more than three years was the biggest driver of slower consumer price inflation, reflecting a sharp fall in the cost of a barrel of oil.

British consumers have been pressured by inflation since June 2016's Brexit referendum triggered a fall in sterling. A year ago, inflation peaked at a five-year high of 3.1%.

But despite the fall in inflation since, and a pick-up in headline wage growth to its highest in a decade, businesses have reported a downturn in consumer spending in recent months.

The British Chambers of Commerce forecast on Tuesday that economic growth this year and next would be the slowest since the country was last in recession in 2009.

Earlier this month the Bank of England sketched out a worst-case no-deal Brexit scenario in which sterling would plunge to parity against the U.S. dollar, inflation would exceed 6% and the economy contract by 8%.

Fed to raise rates and lower rate projections

The Fed will likely raise its target rate by another 25bp to a range of 2.25-2.50% today. This would be the fourth hike this year, the most since 2006. The interest paid on excess reserves, IOER, will most likely be raised by only 20bp in order to bring the effective fed funds rate back to the middle of the target band.

The updated Summary of Economic Projections should show similar economic and inflation projections for the coming three years to those forecast in September. The FOMC members’ rate projections, however, will likely be lowered and indicate a shallower path than before. In particular, we expect the dots to signal only two hikes for 2019 (down from three), and the dots for 2020/2021 might each come down by 25bp as well. The main reasons for the more cautious rate outlook are, in our view, tighter financial conditions as well as concerns about the outlook.

U.S. President Donald Trump has repeatedly berated the Fed and on Tuesday said in a Tweet it was "incredible" for the central bank to even consider tightening given global economic uncertainties.

Comments by Fed Chairman Jerome Powell in late November that the key interest rate was “just below” neutral, a level that neither brakes nor boosts the economy, have bolstered investor expectations that U.S. central bank is nearing a pause on its monetary tightening.

The Ifo index in December declined strongly to 101.0 from 102. It was the fourth consecutive monthly decrease and the lowest level since September 2016. Especially the business expectations component deteriorated further to 97.3 from 98.7. The current assessment reading also declined to 104.7 from 105.5.

There is no denying in that the latest business sentiment indicators were worse than expected. The forward-looking business expectations component, our favorite early-bird indicator, declined strongly for the fifth month in a row and hit its lowest level in four years. Especially the export-dependent manufacturing sector took a heavy knock. At year-end 2018, the number of pessimists among business managers was larger than the number of optimists.

Given the latest deterioration, it is important to remain level-headed. To be sure, one should track sentiment indicators closely these days, since both economic and political risks have been rising. However, we think that special circumstances still argue for a rebound in the German economy anytime soon. More important, fundamentals speak against a doom and gloom scenario in 2019. While the signs of weaker momentum are obvious, one should keep a sense of proportion. GDP growth of at least 1.5% next year still seems feasible.

After shrinking economic activity in the third quarter of 2018, many investors have been discussing recession risks. The latest Ifo figures are certainly grist to the mill of growth pessimists. However, as being said previously, we think that the likelihood for a second consecutive quarter in which the German economy shifts into reverse gear is low.

Industrial production in October disappointed. However, this does not call the rebound itself into question. It just needs more time to unfold, as underlying momentum has started building. New orders in the auto sector were nearly 5% above the level in the third quarter. By the way, the latest Ifo business sentiment data for car manufacturers in December also showed a rebound. Business expectations even hit their highest level since the start of 2018.

It is reasonable to assume that private consumer expenditures will continue to grow solidly in the light of sound fundamentals as a further recovery on the labor market and significant wage hikes. Just to give two (backward-looking) figures for the first three quarters of 2018: about 350k jobs liable to social security contributions were created; wages increased by nearly 3% yoy.

What is more, we think that the boom in the construction sector will continue. Despite the recent ramping up of production activities, there is still huge excess demand for houses and condominiums from previous years. The upswing will therefore run its course further.

Fiscal policy should support GDP growth. According to a recent estimate of the German Council of Economic Experts, the growth impulse from fiscal policy could be up to 0.5pp in 2019. Huge fiscal surpluses, the need to spend more money and political considerations among policymakers in the grand coalition play an important role. 2019 is likely to see a paradigm shift in German fiscal policy, a largely underestimated pattern.

The bottom line is that one should not get too pessimistic. While the risks to exports, and hence also to capex spending, are undeniable, domestic demand will keep the economy afloat.

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