In 2015, as it started its rate hiking cycle, we observed the US Federal Reserve (the Fed) was embarking on a ‘voyage of discovery’. Many of the questions we previously thought we knew the answer to were suddenly a lot more uncertain in the post-Global Financial Crisis world.
As we started to think about the outlook for interest rates, we were pondering questions such as: Where is the new non-inflationary potential rate of GDP growth? What level of the unemployment rate represents the new non-accelerating inflation rate of unemployment or NAIRU? Where is the new neutral Fed funds rate?
The answer that has changed the most demonstrably is the neutral Fed funds rate. We can monitor the evolution of that thinking over a period of time by observing the shift in the median estimate of the long-run Fed Funds rate by the Federal Open Market Committee (FOMC) as published in the quarterly Statement of Economic Projections. In 2012 the Committee, on average, thought the neutral Fed funds rate was 4.25%. Over the ensuing six years that estimate has steadily been reduced to 2.9% currently.
In September, the FOMC delivered its third 25 basis points (bps) interest rate increase this year and eighth of the cycle overall. After 200 bps of tightening, the current target rate range of 2.0% - 2.25% is getting closer to neutral. Indeed, in its September statement, the Committee dropped its reference to monetary conditions being “accommodative”. We await the release later this week of the minutes of the subsequent November meeting for more insights into their current thinking.
Absent a reason to change the scenario of GDP growth running at a faster than trend pace, solid employment growth, a falling unemployment rate, accelerating wage growth and a target Fed funds rate below the current best estimate of the neutral rate, predicting the Fed would hike interest rates four times this year was not the most challenging prediction to get right in 2018.
Admittedly, there’s still one hike to go to be right, but it always seemed to us that the interest rate outlook in the US would be a bit more uncertain as we entered 2019 as the target Fed funds rate approached the current estimate of the neutral rate.
All the data points to the Fed continuing to progress towards neutral. GDP growth has peaked but we expect it to remain ahead of potential and therefore continue to absorb spare capacity. The unemployment rate is at 3.7%, which is a 49-year low and below most estimates of neutral, and average hourly earnings hit 3.1% in the year to October, their highest level in nearly a decade.
At the same time, however, core inflation has come off the boil. After peaking at an annual rate of 2.4% in July, it has since moderated to 2.1% in the year to October, still in line with the FOMC’s 2% inflation part of their dual mandate.
More importantly, it’s consistent with developments in the labour market. In terms of impact on inflation, while we talk a lot about the importance of wage growth, it is changes in unit labour costs that are more critical. The best way to think about that is as growth in labour productivity has consolidated at just over the 1% level (better than it was in 2015-16, but still low by historical standards) and nominal wage growth has reached 3%, that’s broadly consistent with core inflation of close to 2%.
Current forward guidance suggests the Committee will continue to hike beyond the neutral rate so that monetary conditions become moderately restrictive. But that’s far from a done deal.
For now we expect the Fed will continue to press on towards neutral. With the current estimate of neutral at 2.9% and the current target rate of 2.0% - 2.25%, it will take three more hikes in December, March and June to get there. Certainly a December hike is highly likely and we’d put the probability at higher than current market odds of 70%. March and June hikes aren’t set in stone but are more likely than not.
Once at neutral, we expect the FOMC to pause and observe developments in the real economy before determining next steps. Important factors will be how well GDP growth holds up (2019 looks okay but we worry more about 2020, particularly as fiscal stimulus fades), the tightness of the labour market and implication for wages, and the strength of business investment in prolonging the economic cycle and delivering gains in labour productivity.
One thing that seems clear is that slowing segments of the global economy, whether Europe, China or emerging markets, are of limited relevance to the path of Federal Reserve policy. While the Fed Chair Jay Powell referred to slower world growth in recent comments, he did not imply that this had material impact on the Federal Reserve Board’s current view of the US domestic trajectory. That means in practice that the global economy would need to slow dramatically next year to bring the Fed’s ‘pause’ forward in time.
Similarly, equity market volatility is only likely to impact on the pace of interest rate normalisation if it were to become severe enough to dampen consumer activity. Neither of these risks are in play at present, and although share markets remain fragile the Fed will be determined not to give the impression that they are reacting to recent Presidential criticism. A steady course is for all these reasons still the most likely scenario, supporting US bond yields and the US dollar through year-end.
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