Vindication for the Fed’s Plans for Gradual Normalization

2018/04/25
Vindication for the Fed’s Plans for Gradual Normalization

Summary

The latest US economic data appear to support the Fed’s strategy and match the market’s expectations: no rate rises after the FOMC’s May meeting, but three or four hikes by the end of the year. Longer term, however, the market’s expectations don’t match what the Fed is likely to do, which could create turbulence.

We expect interest rates to be left unchanged at the next meeting of the Federal Open Market Committee in early May. Recent economic indicators and surveys do not seem to justify a shift in the Federal Reserve’s strategy of gradual monetary-policy normalization:

  • The Fed’s latest Beige Book – a qualitative report on economic conditions – appears to vindicate its positive assessment of the US economy.
  • Business indicators remain firm, despite some uncertainty associated with protectionist threats from the White House.
  • There has been no notable increase in upward wage pressure.
  • Inflation rose moderately in March, with the consumer price index (CPI) reaching 2.4 per cent and the personal consumption expenditure (PCE) index hitting 1.6 per cent. This appears to confirm the Fed’s view that inflation is moving towards its medium-term target, and that the factors that were previously capping prices have dissipated.

All told, these data points seem to support what the market is already anticipating: the central bank’s intervention will be gradual, and there should be a total of three or four rate rises in 2018. Investors are therefore unlikely to react to the next batch of FOMC minutes. Instead, we believe they will feel reassured by the Fed’s clear forward guidance for 2018.

Longer term, the Fed’s outlook seems to be diverging from the market’s, which may create turbulence:

  • According to the “dot plot” – a snapshot of each FOMC member's interest-rate forecasts – the Fed will raise rates five times between late 2018 and the end of 2020, targeting a terminal rate of 3.25 per cent.
  • That means the US central bank is halfway to its target, given the current fed funds rate of 1.75 per cent and the 150 basis points in hikes the Fed has implemented since December 2016.
  • Investors, on the other hand, do not believe this scenario: they are only pricing in two hikes for the same time period.

We expect this divergence to trigger future volatility, and it may undermine long-term rates if investors adjust their expectations to more closely resemble what the central bank is likely to do.

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What's the problem with productivity?

2018/04/27

Summary

Productivity is the key driver of global economic growth, but it has stayed puzzlingly low despite a string of high-tech innovations. Ageing societies are making matters worse. If the world doesn’t fix the productivity challenge, we may be sentenced to a lower-growth environment for years to come.