Each quarter, lead portfolio managers and sector specialists from across our Global Fixed Income, Currency & Commodities (GFICC) platform gather at our Investment Quarterly (IQ) meeting to provide valuable insight into their sectors, debate factors likely to influence the markets over the coming quarters, and establish themes that will guide our investment strategies. One of the outcomes from the December IQ was our 2018 interest rate forecast that was higher than both forward rates and Fed projections. So far this year interest rates have moved quickly towards our expectations and events we flagged as significant watch-list items back then warrant a refresh of our US rates outlook.
Since we met in mid-December, we have seen our “Higher rates” watch-list items flash red. Passage of the tax bill, and more recently, an agreement to lift government spending, are the most notable. Combined, these bills represent a major change in fiscal policy which raise our expectations for GDP growth in 2018 and 2019, increase cyclical inflationary pressures, and may bring forward Fed rate hikes. There is potential for additional spending on infrastructure as well. This takes place in a backdrop where wage inflation, as measured by average hourly earnings, has recently recovered from Q4 weakness. This continues the three year rising trend. Recent Fed speakers have signaled comfort with raising rates three times this year, suggesting the Fed is not jarred by the recent equity sell-off and rising volatility. This is partly due to financial conditions indices which are still signaling easy conditions.
There remain risks to lower interest rates. Q1 growth indicators such as Wednesday’s Retail Sales report could continue disappointing expectations while technical indicators suggest Treasury yields may decline in the near term. Longer term, structural inflation headwinds related to technology could pick up or other risks noted above could materialize. Our team will continue to monitor these watch-list items through our robust process to identify attractive opportunities in the Treasury market in either direction.
All that said, we are biased towards higher rates in 2018 as continuing strong growth and cyclical inflation pressures will be further supported by increased US fiscal expenditures. As a result, we are raising our year-end 2018 US forecast to include four Fed interest rate hikes this year (up from three) and to increase our expectation for 10-year Treasury yields to a 3 – 3.5% range (up by 0.25%). We will continue to discuss and debate market events in the context of our forecast as part of our globally integrated, research driven process.
Is the Fed moving the goalposts? This is a common question that Fed watchers grapple with as we seek to anticipate whether or not the FOMC will raise interest rates. If you want to be literal, the answer is no; the Fed’s objectives are set by Congress and haven’t changed since the 1970s. The Fed can’t move the goalposts unless Congress moves it for them. That’s a narrow interpretation. The Fed has been accused of time-inconsistency before. Think back to 2012, when the Fed first mentioned a 6.5% unemployment rate as a key threshold to keep rates low and policy accommodative. Though unemployment broke through 6.5% in early 2014, the first rate hike did not come until December 2015.
The Fed’s dual mandate is quite broadly described as price level stability and maximum employment. It is then up to the FOMC to further interpret these goals and determine the best means to achieve them. Because the mandate is vague, the Fed has taken steps over the past two decades to more clearly define its objectives. While it is helpful that the Fed is now more transparent, it nevertheless maintains the flexibility to change a definition to better achieve a stated goal. This can make it difficult to forecast future rate hikes, especially with a new Chairman and voting Committee members. Unsurprisingly, the market has been sensitive to the fact that the Fed could shift its framework in 2018.
By most measures the Fed has achieved maximum employment. The current unemployment rate is below most estimates of the natural rate, and wages are gradually rising. Other measures show that a bit more slack remains, such as the employment to population ratio for prime-age workers, which may be why wages aren’t rising faster. The bottom line is that the unemployment rate is the lowest in 16 years and Ben Bernanke and Janet Yellen should feel pretty good about that. The FOMC has never felt much pressure to define the employment target numerically because it shifts over time due to factors, such as technology, that are beyond the control of the Fed.
In January 2012, the Fed set an official target for inflation of 2% as measured by the annual change in the price index for personal consumption expenditures (PCE). Each year, they re-affirm this strategy at the January meeting. More specifically, they state that the Committee would “be concerned if inflation were running persistently above or below” the 2% objective. In 2017, the Fed amended its longer-run goals document by inserting an additional description of the inflation target that it is “symmetric”. Every year that the US economy continues to recover, but inflation runs below the Fed’s objective of 2% (which the PCE measure has done more frequently than other measures such as the Consumer Price Index [CPI]), the “symmetric” description is even more important. In the current recovery, we’ve spent so much time trying to get to 2%, the question now is, what happens when we actually get there? You could argue that with 5-year inflation breakevens in the US at ~1.95%, the market is not pricing in any risk of inflation increasing beyond 2%, despite the fact that over the past five years, inflation has been below the Fed’s goal. Not to mention, inflation breakevens are priced off CPI, which tends to run 20-40 bps above PCE.
Maybe just communicating that the target is symmetric isn’t enough to convince the market that it is so. Perhaps the target wasn’t efficient to begin with because we haven’t been able to achieve it. A number of FOMC members have spoken about alternatives such as price-level targeting. Price-level targeting is a more technical and binding way of stating that the inflation target is symmetric. A price-level target of 2% over a horizon of five years means that over any five year horizon the average annualized rate of inflation should be 2%. This implicitly means that when inflation runs for two years below 2%, it will need to run above 2% for two years to catch up and maintain the same original path for the price level, as illustrated in the figure below (but in the opposite direction). I believe the discussion is more important than the ultimate implementation. The key consideration is when the Fed actually does hit their inflation target that they credibly convince the market that they won’t act too aggressively by treating the target as a ceiling. If the markets perceive that once 2% is achieved that the Fed will attempt to stop any further acceleration in prices, then financial conditions will tighten and the prior progress made will be easily self-defeated.
The Fed’s ability to make changes independent of the Federal government is an advantage in many ways. In an environment of historically low interest rates and growth, the Fed’s ability to ease financial conditions and control inflation expectations is exceptionally important because their traditional tool set is limited. For example, if the Fed can only lower the Fed Funds rate by 200 bps in the next downturn, this may not be sufficient. But if the Fed can also, simultaneously, raise inflation expectations by 100 bps because markets anticipate future monetary policy will be especially easy to offset the weakness in realized inflation and growth in the coming years, the Fed’s easing program will be more powerful. They will be able to effectively lower real rates by an extra four rate cuts.
But don’t be too quick to assume that price-level targeting is a panacea. Changing the target is only effective if the market assumes the Fed is credibly committed to the policy and can actually generate more inflation. If the target is changed but the market does not view the Fed as credible, they are in an even worse spot. The Fed is already raising rates while inflation remains below its current target. A Fed that is perceived as not able to achieve its goals, allowing inflation to rise, will ultimately cut off growth, and thus, kick-start the next downturn.
My humble suggestion to the Fed: wait until PCE inflation actually achieves the 2% target and only then shift the objective to a more explicit price-level targeting regime. Shifting too early, before the current goal is achieved, is admitting defeat. It also will increase the market’s perception that whenever something appears to not work for a period of time, the Fed could just change it, thus reducing the credibility of all targets to begin with. Once the objective is changed, the Fed should set limits on how often the target is re-evaluated.
So, what will the Fed actually do? Nothing anytime soon! The January FOMC meeting came and went. The Committee re-affirmed its existing strategy of gradual rate hikes and a 2% inflation target, for now. Expect the minutes from the January meeting (when they get released towards the end of February) to discuss this topic further. In addition, watch for Powell’s testimony to Congress at the end of the month. Just because the Fed won’t make formal changes in 2018, doesn’t mean that the market won’t look for and anticipate changes in advance. If anything, this should mean more interest rate volatility and higher inflation risk premium, given the possibility that the Fed’s framework could be changing. With global growth continuing to surprise to the upside and a notable increase in US fiscal spending coming over the next two years, it is possible that we reach 2% inflation sooner than planned. The discussions will get more interesting once we get there. At that time, the Fed will be forced to address how they really view their inflation mandate or if they will move the goalposts.