Financial markets stumbled up and down on worries the Fed was moving too quickly, but Powell’s recent wavering is raising the odds of a pause.

In December, the Fed raised its benchmark interest rate by 25 basis points, lowered growth projections, and limited the number of future hikes. The central bank took the federal funds rate to a range of 2.25% to 2.50%, the fourth increase of 2018 and the ninth since it began normalizing rates in December 2015. The Fed also made a slight modification in its December statement, stating that it expects “some” further gradual increases in rates. In a press conference following the rate meeting, Fed chair Jerome Powell said recent market developments have not “fundamentally altered the outlook.” The markets nosedived.

Since then, the Fed seems to be struggling a bit to get its message across. Part of the problem is the uncertainty over exactly what the message should be. At Powell’s press conference in December 2018, the central bank exposed the box it has put itself in by banging on about the current strength of the economy when it’s the outlook that matters. It may also be the case that the Federal Open Market Committee (FOMC), which sets rates, was distracted by Trump’s public ruminations about firing Powell.

The Fed seems to be struggling a bit to get its message across.

Just days after Powell spoke, New York Fed President John Williams was on CNBC to try to “clarify” the FOMC’s message. Williams said the central bank is listening “very carefully” to the market’s concerns on growth but believes the U.S. economy is in good shape. Since then, we have heard from a number of other FOMC members, offering one insight or another. In early January, Powell said that low inflation would allow the Fed to be “patient” in deciding whether to continue raising interest rates. He also said the bank will “watch’’ how the economy evolves. Those comments were welcomed by investors.

Listening to the markets

It’s becoming clear the Fed is beginning to take seriously what is now worrying the markets — weaker global growth, the widening consequences of the China–U.S. trade war, and financial market volatility. The U.S. economy is less dependent on global demand than the economies of most of other countries. Still, China is large enough and well-enough integrated globally that even the United States cannot shrug off its deceleration.

More important is the sheer uncertainty about the trade relationship with China and the rest of the world. If there is a deal between Trump and Chinese President Xi Jinping, what will it cover? Will the administration impose tariffs on autos imported from Europe? There is genuine uncertainty among investors about these issues.

What will cause the markets to stabilize? One of the key indicators is the central bank. In almost all instances, we saw a central bank, especially the Fed, react to market volatility. The bond market rally of the past two months probably reflects expectations that the Fed will step up to ease volatility, if necessary. The overnight index swaps (OIS) market is signaling the Fed may hold interest rates steady in 2019 and puts some probability of a rate cut at the end of the year and into 2020. OIS uses an overnight rate index, such as the federal funds rate, as the underlying rate for its floating portion. Interest-rate swaps involve the overnight rate being exchanged for a fixed interest rate.

But the Fed has not capitulated yet. Policy makers only reduced rate-hike expectations for 2019. For bond markets to rally further and for markets to stabilize, this is probably not enough, at least not yet.

But the Fed has not capitulated yet.

Finding stability amid chaos

Another indicator that can cause markets to react is investor retreat. There has been a lot of talk of withdrawals by institutional investors and fast money. But exchange-traded funds (ETFs) are still attracting inflows. ETFs are big, they have not yet been tested by a major selloff. When they produce outflows, they are likely to move the markets in unexpected ways.

A third indicator is fundamental valuation, but this is difficult for investors to assess. Exactly what are the relevant fundamentals, and how confident can investors be that they can be assessed properly? Will global growth continue to deteriorate or not? Will the trade war end? If global growth stabilizes, emerging-market assets would look attractive at today’s levels. If the global environment deteriorates, that appeal would disappear. But the outlook for global growth is not determined by emerging markets.

A pause?

The sensible course of action for the Fed will be to hold off from raising interest rates. But we are not yet ready to forecast the first cut. It is also important to note the Fed is not there yet. Clearly, the Fed is having these discussions, and there are some FOMC members who have come to the conclusion that at least a lengthy pause is warranted.

The strong labor market and future indicators of wage growth and declining unemployment will prompt many members of the FOMC to call for further tightening. A shift to a pause would be a decisive shift in the Fed’s assessment. We think risky asset markets are likely to remain vulnerable until we get a clearer signal from the Fed. And if we don’t get such a signal, we will be talking about a policy mistake, with all its attendant consequences.

Next: Emerging markets stay afloat

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Forecasting 2019 means interpreting the interactions between economic growth, interest rates, and risky assets.