The new-look Fed seems committed to low rates, but will face challenges if one thing changes

The Federal Reserve’s policymaking body heads into 2020 with a new complexion that, at least on its surface, seems committed to keeping interest rates low for the foreseeable future.

In an annual rotation of voting members on the Federal Open Market Committee, Fed Presidents Eric Rosengren of Boston and Kansas City’s Esther George head to the sidelines. They are two of the FOMC’s most noted hawks, or those opposing the central bank’s moves last year to lower rates.

In their place will be new members who are expected to apply still more pressure to keep rates low.

Minneapolis Fed President Neel Kashkari has publicly urged his colleagues to pledge no further rate hikes until inflation perks up considerably. Another oncoming regional president, Robert Kaplan of Dallas, has said recently that he is worried about growth in the fourth quarter and thinks policy is in the right place.

The remaining new voters are Cleveland’s Loretta Mester, considered a solid hawk though she voted in favor of each of the three rate cuts in 2019, and Patrick Harker of Philadelphia who advocated in September to keep rates steady though he ultimately voted for the September and October quarter-point reductions.

With the new year just under way, the balance of the committee is expected to a follow a philosophy that Chairman Jerome Powell expressed in December when he said the Fed would need to see inflation “that’s persistent and significant” before moving on rates.

“‘Don’t fight the Fed’ is sage advice … Powell gave the greenlight to investors that there will be no rate hikes for the foreseeable future,” Bespoke Investment Group founder Paul Hickey said in a note. “It’s also notable that changes to the voting bloc of the FOMC in 2020 will mean more consensus” as the committee’s makeup gets more dovish.

Chicago Fed President Charles Evans echoed that position, telling CNBC in a Friday interview that he remains concerned about the lack of inflation, which by the Fed’s preferred measure is running at just 1.6% excluding food and energy.

“I think it’s an environment where inflation ought to be rising up to 2%,” Evans told CNBC’s Steve Liesman. “We really ought to be getting inflation above 2% to show that it’s a symmetric objective. If it goes to two and a quarter or two and a half, that would be all right with me.”

Evans said he thinks the Fed ought to keep policy where it is until it clearly meets its price stability mandate.

Getting the Fed to move from that position, though, may not be as tough as it seems.

After all, officials ended 2019 diametrically opposite from where they stood in 2018.

Heading into last year, the Fed was forecasting multiple rate hikes and a reduction in the bonds on its balance sheet that was on “autopilot,” as Powell stated in late 2018. As 2019 closed, the outlook was for no moves in either direction with a balance sheet increase that ultimately could take the bond portfolio beyond its historic peak.

Underscoring both positions was a commitment to data dependence — Powell and his colleagues repeatedly have stressed that the policy is not preset and can always change according to conditions.

Should economic growth and inflation in particular pick up, the Fed very well could have to tighten, according to Jim Paulsen, chief investment strategist at The Leuthold Group, who is bullish on 2020 growth and thinks inflation is being underestimated.

“The sand on inflation could shift in a hurry,” Paulsen said. “When you’re playing with a 3.5% unemployment rate and you have full-on policy juice coming from all over the globe like we’re in the pit of one of the worst recessions ever, that’s quite a combo.”

Paulsen points to a variety of indicators: inflation as measured by the consumer price index (2.3%), three-month wage inflation (3.1%) and commodity prices, which are still down for the year but off their lows. Trimmed inflation measures from Fed districts that remove volatile items also show around 2%.

He added he thinks inflation has only paused, but will catch up to the bull market. “Consequently, the biggest financial risk, and perhaps the biggest potential surprise in 2020, could be an inflation rate that recovers much more quickly and aggressively than expected,” he wrote.

Paulsen is one of the few strategists who sees the Fed facing a greater potential for a rate hike this year than the 50-50 chance the market is assigning of a cut by December. He said the most likely case is the Fed stays on hold “for much of 2020” though that could change by the end of the year.

The Fed now targets its benchmark interest rate in a range of 1.5%-1.75%. Critics say the central bank has plenty of ammunition to tighten policy should inflation surge, but little left to do in case of a downturn.

Calibrating how to get through an uncertain picture for the economy will be the biggest challenge for the new FOMC voters. Former Fed Chairman Alan Greenspan recently told CNBC that he, too, thinks the central bank will have to confront rising inflation pressures ahead.

“What if inflation picks up but growth doesn’t and you start seeing signs of stagflation? That puts the Fed in a difficult spot,” said Quincy Krosby, chief market strategist at Prudential Financial. “This is a question that investors have in general. What can the Fed do, given that the toolkit is so bare?”