Comment: Expect more market turbulence as Fed normalises
In line with expectations, the Federal Reserve raised short-term rates by 25 basis points on Wednesday to a range of 1.50%-1.75%.
In the run-up to the meeting, futures markets had set the chance of an increase at 97%. Fed Chairman Jerome Powell and various colleagues reinforced that confidence with hawkish comments to legislatures and the public. Those sentiments were echoed in the committee’s press release, which cited strong job gains, low unemployment and moderate improvement in the economy as supporting the increase.
This is the first rate hike of Powell’s brief tenure and comes at the time when the FOMC finally has a more complete picture of fiscal stimulus and its potential impact on the economy. It also comes on the heels of truly impressive GDP numbers for the second half of 2017. Various headwinds of 2014-16, including a ‘profit recession’ and economic weakness in emerging markets tied to a then-strong US dollar, are a thing of the past.
Perhaps the most significant turnabout is in the jobs market: in the three months through February, an average of 242,000 US jobs were created each month compared to an average of 167,000 created in the three months which ended in November. All the while, the Fed has continued to press gently on the brakes via steady rate hikes and a slow removal of quantitative easing.
How many more hikes?
Recent market tension has focused on how many increases we will see this year. Powell sounded fairly hawkish before Congress last month, as did a number of his FOMC colleagues in their public statements. However, he took more of a middle ground in his press conference yesterday, perhaps to maintain optionality on rates going forward.
Given Powell is new and likely does not want to jar the markets too quickly, we believe the committee will come through with a total of three increases in 2018, barring unusual circumstances – though nearly half of FOMC members would like to see four increases – and then probably go with another three in 2019.
The task will be to maintain a balance between overheating the economy – especially as we received fiscal stimulus when the economy was already operating at potential – and restoring inflation to the symmetric target of 2%. Look for some overheating of the economy to bring inflation to that target before the steeper path of the dots pulls conditions back into line.
A move away from secular stagnation
It is important to keep in mind that the narrative throughout the Janet Yellen era was one of secular stagnation. When the FOMC first started sharing individual member forecasts in 2012, the mean terminal, or peak, Fed funds rate was around 4%. As their view of economic potential dwindled, that figure drifted down to 2.8% in December and has just inched up to 2.9%. Whether this general decline can be reversed is a key question, but there are positive signs.
On a final note, yesterday’s meeting is notable for pushing the real Fed funds rate into positive territory for the first time in a decade. The impact of this transition should not be underestimated and introduces new variables to the macroeconomic environment – most obviously an increased level of volatility for both equities and bonds. As the real Fed funds rate becomes normalised, we should expect more turbulence and an eventual, and intentional, slowdown in economic growth.
Thanos Bardas is head of interest rates at Neuberger Berman