The Market’s Mistaken View on Fed Rate Hikes

The consensus view of the financial markets suggests that the FOMC will next raise its target Fed Funds rate in December (by a quarter point).  Currently, the target range is 1.00%-1.25%. Fed Funds futures currently suggest (as of July 13) a 97% probability that the Fed Funds target rate will remain unchanged at its upcoming meeting on July 26. The current probability of the target rate remaining unchanged stays high until December, when the probability of a quarter-point increase rises to 49% and a half-point increase rises to 8.4%. Thus, the Fed Funds futures market does not see a better than 50% probability of any increase until December.  Most economists and market strategists echo the view of the futures market.

The rationale for a five month delay in the next FOMC move is based upon the notion that that continued increases could present headwinds for the U.S. economy.  While expectations of a pick-up in economic growth were high coming off the election, they have since moderated, in part because of the Trump administration’s inability (so far) to get key legislation passed.

On top of this, the price of oil has declined sharply and steadily for most of the year.  The price of natural gas, which was expected to begin rising this year, has remained stubbornly range bound and is down for the year.  The decline in both oil and natural gas prices has reduced the outlook for headline inflation to below the Fed’s 2% threshold.  Thus, there seems to be less urgency now to normalize the Fed Funds rate.

Despite this more tepid economic outlook, employment growth has remained surprisingly strong.  Most economists have been looking for employment gains to moderate as a result of both the advanced age of the economic expansion and the already low unemployment rate.  Relatively weak payroll numbers in April and May supported that view.  However, the June payrolls report, with positive revisions for April and May, repainted the picture, suggesting that job gains have been steady and solid so far in 2017.  The average monthly gain in payroll employment so far in 2017 is now 180,000.  That is down from 251,000 in 2014 and 229,000 in 2013, but on par with 2016’s 182,000.  More importantly, the unemployment rate was estimated at 4.4% at the end of June, compared with 6.6% at the beginning of 2014.

The Federal Reserve’s mandate from Congress, as noted in the first paragraph of every Monetary Policy Report, is threefold:  to promote maximum employment, stable prices and moderate interest rates.  Monetarists cringe at the first goal, arguing that the Fed should focus solely on prices and interest rates primarily because monetary policy is at best a blunt tool for achieving macroeconomic goals.

Unemployment is now modestly below the FOMC members’ 4.6% median estimate of the long-term trend.  Since the FOMC has not indicated that it views the Bureau of Labor Statistics’ employment figures as inaccurate or misleading, it is reasonable to conclude that the Fed has achieved its maximum employment objective.  Gains in hourly wages have been modest, but with less slack in the labor force, it is conceivable that they could begin rising at a faster clip before too long.  However, most economists would say that the slow gains in productivity make faster wage gains unlikely.

The FOMC has set a 2% target for consumer price inflation, as measured by the annual change in the price index for personal consumption expenditures as calculated from the GDP data.  Annual PCE inflation bottomed at 0.3% in 2015 and rose to 1.1% in 2016.  In the 2017 first quarter, the year-over-year change in the PCE price index increased to 2.0%.

Changes in the PCE price index seem to correlate pretty well with changes in oil & gas prices.  While first quarter PCE inflation was equal to the Fed’s inflation target, the recent decline in oil & gas prices suggests that the year-over-year change in PCE prices will moderate in the second and probably the third quarters. Thus, it is likely that annual change in PCE prices will be below the Fed’s 2.0% target once again in 2017.  The median estimate of FOMC members for 2017 PCE inflation is currently 1.6%.

Even so, FOMC members believe that inflation will reach the Fed target in 2018 and 2019.  (The median estimate of FOMC members is currently 2.0% for 2018 and 2019 and 2.0% beyond 2019.)  Thus, the FOMC expects that inflation will rise from current levels to the Fed’s 2.0% target by 2018. That suggests that the Fed is on the verge of achieving the second objective of its mandate.

In its latest statement, the FOMC said that it thought that the near-term risks to the economic outlook appear roughly balanced, but that it was monitoring inflation developments closely. That suggests that the FOMC sees the near-term risks on inflation weighted more toward the upside. If so, then the FOMC should be moving to normalize rates at a faster pace to tamp down potential inflationary pressures.

The third objective, moderate interest rates, seems moot because interest rates remain near historically low levels.  The yield on the 10-year note is currently 2.35%, which is above its July 2016 historic low of 1.34%; but also well below pre-2008 financial crisis levels of around 5.00%.

Real interest rates are also well below historical averages.  By my calculations, the spread between the 10-year yield and annualized CPI inflation has average 86 basis points since the financial crisis, down from 265 basis points pre-crisis.  The 10-year-CPI spread is currently about 50 basis points.

By almost any measure, therefore, interest rates are low, arguably too low on a sustainable basis. The third objective of the Fed’s mandate has clearly been met.

With all three objectives now in hand, it seems that the Fed should proceed with the normalization of the Fed Funds target rate as quickly as possible. Those that argue for a slower approach say that the economy is still shaky and inflation is still low, so the Fed can afford to take its time.  Similarly, there are concerns that a fast increase in U.S. rates will lead to a sharp increase in the dollar, which could put more pressure on U.S. exports and countries that borrow in dollars. I agree that there is still considerable uncertainty regarding the growth of the U.S. economy; but there is still a good chance that growth could pick up.  FOMC members currently expect that GDP growth will remain stuck at around 2%.

Still, the Fed’s mandate does not extend to industrial production or the U.S. dollar.  If the employment mandate has been met and the risk of inflation is skewed to the upside, the Fed should be taking steps to normalize short-term rates as quickly as possible, unless there is clear evidence that doing so would cause it to fail in its mandate.

There is a legitimate argument as to what a normal Fed Funds rate should be in the current environment.  Most importantly, the Fed should not risk inverting the yield curve, since that has been highly correlated with a slowdown in economic activity.  If longer-maturity Treasury yields remain at very low levels, there should be a limit to how high the Fed can push interest rates.

Yet, the recent increase in the 10-year Treasury yield from 2.10% in mid-June to 2.35% gives the FOMC cover to raise rates again.  The current spread between the two-year Treasury note yield, which is considered by many to be the indicator of Fed policy on the Fed Funds rate, and the 10-year Treasury yield is about 100 basis points.  That spread has averaged 186 basis points since the start of the financial crisis.  By comparison, it averaged 103 basis points from 2000 to the start of the financial crisis and 49 basis points from mid-1994 to 2000.  Consequently, there appears to be room to raise the Fed Funds target by 25 basis points now.

Unless the 10-year yield drifts back to June levels (thus reducing the 2-year to 10-year spread, I think that the FOMC should take advantage of the today’s wider spread and raise the Fed Funds target rate at its July meeting.

For now, the 2-year, that indicator of Fed policy, is 50 basis points below the rate of CPI inflation.  Since the onset of the financial crisis, the 2-year spread to inflation has been 90 basis points below the CPI on average.  From mid-1994 to 2000, it averaged a 320 basis points above the CPI.  From 2000 until the start of the financial crisis, it averaged 44 basis points above. I think that under current market conditions, it is unlikely that we will see a return of the 2-year-CPI inflation spread to pre-2000 levels; but I believe that a good case can be made that the spread between the two-year yield and CPI inflation should be positive as soon as possible.  That suggests a normalized Fed Funds rate of around 2.25%-2.50%, which should coincide with a 10-year yield probably around 3.00%.

The financial markets are indicating that the FOMC will hold the target Fed Funds rate steady at its July meeting. Maybe so.  Yet, without clear evidence of a slowing in economic activity (including a rise in unemployment), I think that it is highly unlikely that the FOMC will wait until December to raise the Fed Funds target again.  Indeed, waiting that long under current market conditions would probably be a mistake.

July 13, 2017

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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