With today’s rate hike, the U.S. Federal Reserve (the Fed) has now taken steps to tighten monetary policy at each of its quarterly press conference meetings dating back to December 2016. The rhythm and predictability of its decisions have helped dampen volatility in financial markets. Indeed, today’s decision to raise the target range of the federal funds rate from a range of 1.50-1.75% to 1.75-2% was universally expected by economists.1
The details of today’s meeting were slightly hawkish. The Fed’s median interest rate forecasts for 2018 and 2019 both moved up by 25 basis points, but admittedly those changes were quite small. In the 30 minutes surrounding the announcement, the 10-year U.S. Treasury yield rose from 2.95% to 2.99%, the yield curve flattened, and the S&P 500® Index fell by 0.1%.
Rather than obsessing over the likeliest timing of the next rate move (answer: September), we believe investors are better served looking at the big picture. Ultimately, we think there are four big unanswered questions for U.S. monetary policy:
What catalysts would cause the Fed to deviate from the quarterly rhythm it has established?
The hurdle for the Fed to change course is high.
Not too fast
We think a four-hike pace is the speed limit for the Fed in this expansion. A faster trajectory would require hikes at sequential meetings, which would be a big surprise for markets. The dot plot suggests little appetite from the Federal Open Market Committee (FOMC) for a faster pace. And the detailed minutes from the Fed’s May FOMC meeting suggest a willingness to tolerate “a temporary period of inflation modestly above 2 percent.” Translation: Barring a significant surprise in which core personal consumption expenditure (PCE) inflation runs persistently north of 2.5%, we believe the Fed will not speed up.
Not too slow
On the flip side, the unemployment rate stands at a 49-year low of 3.8%.2 The Fed feels content about the achievement of its full employment mandate. And this will likely act as a strong catalyst for the central bank to keep hiking to prevent the economy from overheating over the medium-term. We believe the fact that the Fed was willing to look through downside surprises to both the growth and inflation data in mid-2017 is indicative of their biases in this regard. In our view it would take a major growth scare to derail the Fed—whether that be a geopolitical event that endangers the medium-term outlook or a fundamental recession scare per early 2016.
At what level of rates does policy switch from being accommodative to restrictive?
With the Fed under pressure to continue its tightening cycle in the short-run, the question naturally turns to when that process will mature to the point where monetary policy becomes a hindrance to the growth outlook. To answer this question, economists focus on the idea of r-star—the neutral rate of interest where policy switches from being accommodative to restrictive. Unfortunately, r-star isn’t observable and its estimation is subject to considerable uncertainty. But most estimates of it have come down considerably over the last few decades. Leaning on the expertise of John Williams, president of the Federal Reserve Bank of San Francisco, and our own assessments, we think the nominal neutral rate is around 2.5%, or slightly less. Put differently, the Fed can only deliver two or three more rate hikes before it starts to take the punch bowl away from the party.
How willing will the Fed be to push rates into restrictive territory?
Barring former Fed Chairman Paul Volcker’s battle against inflation in the early 80s, there are very few examples where the Federal Reserve intentionally killed an expansion. The more common scenario, similar to today, is that the central banker sees evidence of overheating and subsequently raises rates—not to cause a recession but to nudge the economy back down to a more sustainable growth rate in the long-run.
The challenge is that getting the policy setting exactly right is incredibly difficult in practice. This is an extreme analogy, but in some ways monetary policy is like trying to shoot a moving target (the medium-term economic outlook is uncertain) from 100 yards away (monetary policy acts with a lag) while standing on a wobbly chair (the Fed doesn’t know exactly where it’s standing with its policy stance today). Central bankers are very smart and do their very best, but it’s a difficult job to get exactly right. Hiking too quickly risks a downturn. Hiking too slowly risks imbalances, asset bubbles and an inflation overshoot.
There is a debate on the current Committee about the need to push policy into restrictive territory at some point. Assuming inflation holds close to the Fed’s 2% target, most policy rules suggest they should. The unemployment rate is plumbing multi-decade lows and imbalances are emerging in financial markets in the form of elevated asset valuations and aggressive nonfinancial corporate debt use. The bias and pressure will likely be for the Fed to continue a gradual transition into restrictive territory. The leaders of the FOMC generally seem to support that view and have expressed a willingness to invert the U.S. Treasury yield curve.3 If and when we get to that point, the risk to financial markets will likely increase considerably.
Will the Fed change its inflation target before the next recession?
The final watch point is around any changes to the Fed’s policy goals or framework. In particular, there has been debate recently in academic and central banking circles about the merits of shifting to a higher inflation target or, alternatively, committing to make up for downside misses on inflation by letting inflation overshoot for a period thereafter (price-level targeting). The arguments for these changes are straightforward. With a low neutral rate, it’s likely that the Fed will be confronted by the zero lower bound on interest rates again during the next recession. In addition to its unconventional toolbox, a higher inflation target would allow real interest rates to move more deeply into negative territory.
We will continue to comb through Fed research papers, meeting minutes and research symposiums to look for whether or not a consensus is building on this issue. At this stage, our bias is to conclude that such a policy change, while merited, is unlikely before the next recession. The Fed is a conservative institution and is very careful about making changes to its operating framework. Crisis is often the easiest catalyst for action and change.
Key questions going forward
With the Fed having established a rhythm to its hiking process, markets have been able to latch onto this and we see little scope for surprise in the short-run. As such, we believe the U.S. 10-year Treasury yield looks reasonably well-aligned with the three-to-four hike trajectory that the Fed is currently forecasting. Whereas in prior years where we held an underweight preference for rate-sensitive assets, we see the risks to those markets as being more finely balanced today.
The bigger questions for the Fed outlook surround the durability of the expansion and, through that, how long it will be able to maintain the current trajectory of rate hikes. As we get into the second half of 2019 and into 2020, we suspect those end-of-cycle risks will become more elevated—potentially bringing to an end the central bank’s rate-hiking rhythm.
1 Source: http://projects.wsj.com/econforecast/#qa=20180601001
2 Source: https://data.bls.gov/timeseries/LNS14000000
3 Source: https://www.federalreserve.gov/newsevents/speech/brainard20180531a.htm