Turning the Fed Battleship
The Fed hiked interest rates by 25 basis points last week, as expected, but also projected three rate hikes in 2017, an increase from two previously. Investors were caught by surprise, but should not have been. Indeed, we think that more than three hikes could come in 2017, if the Fed is as data dependent as they claim. The point must also be made that an expansionary fiscal policy is fast becoming inappropriate, since the economy is already at full employment. So, the Fed must turn its focus from promoting faster growth to containing inflation. That’s a major change in direction, although the Fed is likely to alter its public statements only gradually to avoid shocking the market. But the increase in projected hikes for 2017 is a small shock already, since the Fed tried to remain apolitical during an election year and must now deliver news of more impending rate hikes.
The market has perceived the Fed as dovish for quite some time, but the truth was always more nuanced. In 2016, it seemed like any excuse would suffice to justify leaving interest rates near all-time record lows. Yet in public speeches, Fed Chair Janet Yellen clearly understood that an overly tight labor market could exert serious upward pressure on labor costs, become embedded in inflation, and tarnish her legacy. Some outside pundits claimed that the Phillips Curve was dead and there was no correlation between unemployment and wage inflation, so interest rates could remain low for some years into the future. Senior Fed officials never shared that extreme viewpoint, even as they struggled to understand how and when inflation might increase. So, they have been consistently cautious about forecasting the possibility that inflation and interest rates might need to rise more than projected. That excessive caution is on full display in their latest projections for the economy.
For 2017, the Fed’s economic projections for GDP range between 1.9% and 2.3%, essentially the same trend we have seen so far. There’s nothing odd here. However, their unemployment rate projection ranges between 4.5% and 4.6%, when the latest report indicated that the unemployment rate is already at 4.6%. In fact, growth around 2% over the past few years has been sufficient to push down the unemployment rate by 0.75% to 1.0% annually, so the GDP and unemployment forecasts are impossible to reconcile with each other. Moreover, the Fed is projecting a minimal increase in overall inflation within a range of 1.7% to 2.0% and for core inflation between 1.8% and 1.9%, despite the rebound in energy costs that we already know has occurred. One could infer that the market is being set up for faster rate hikes, if the Fed’s relatively low projections are exceeded, as seems highly likely to us.
The Fed is also trying to manage policy without surprising or shocking the market, quite a difficult task when politicians loved to take potshots at the Fed during election years and the Fed doesn’t want to be disruptive or even noticed during this sensitive period. Naturally, they did and said as little as possible. But, they sure hinted at the need for rate hikes. Both Yellen and Vice Chair Fischer were very clear when they spoke at Jackson Hole. But the market ignored those comments, or quickly forgot them, because the Fed didn’t hike rates in September. Again, some weaker data was the excuse. But once the election was over, every single Fed official public statement seemed to favor a rate hike, including every known dove on the Committee. So the rate hike in December was the most widely, best anticipated rate hike in Fed history. Not one Wall Street economist got it wrong. (They aren’t that good, but it was just that easy.) But investors failed to think about the possibility that more was needed, partly because the Fed has been so consistently dovish. And there are some senior Fed officials who do not wish to act in anticipation, instead preferring to keep rates down as long as they fail to see clear evidence of higher inflation.
Investors are now in the process of slowly rethinking the consequences of the Fed’s policy projections, while also trying to incorporate their own very preliminary judgments about what might happen to fiscal policy under a Trump Presidency. If Trump gets only a portion of what he has promised, fiscal policy will be significantly more expansionary at the very time the labor market is already below full employment. Most economists understand this implies a heightened risk of rising inflation, whether they are willing to forecast this publicly or not. We do expect inflation to increase and remain positioned accordingly, which has worked well.
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