Late last year, the Federal Reserve was doing some soul-searching. Inflation remained low despite strong growth and low unemployment, and seemed unlikely to head higher any time soon. Questions were raised around the Fed’s economic framework, including whether its estimate of the neutral interest rate should be even lower, and whether the central bank was paying enough attention to the ‘symmetry’ of its inflation target. But even amidst this uncertainty, the plan remained clear. Gradual rate rises, with three as the default path, and with a caution that would allow the committee to pause if the data weakened.
In recent weeks though, that soul-searching has stopped, and we have seen a surprisingly confident and hawkish tone from several Fed speakers. Speaking to Congress on the outlook for monetary policy, the new Chair, Jerome Powell, was notably confident in his testimony. He talked about the need to avoid ‘an overheated economy’ and failed to rule out a default path of four rate rises in 2018. The influential New York Fed representative, William Dudley, also talked about moving to four rate rises around the same time, saying that this would still be ‘gradual’. Even the usually-dovish Lael Brainard gave a sea-change speech, titled ‘Navigating monetary policy as headwinds shift to tailwinds’.
Taken together, the Fed looks set to move up its ‘dots’ — its interest rate projections — up towards four hikes in 2018 at its March meeting.
The Fed appears to have decided three things in the past month then. They do still know what drives inflation; it’s going to rise; and they need to act. In part, this is down to how large President Trump’s fiscal stimulus is going to be. It’s also a reaction to a couple of stronger inflationary data-points, although these are too volatile to give a true picture for now.
But what’s to stop the Fed having another change of mind, or a crisis of confidence? The Fed sounds self-assured now, but that’s easy to do after a long period of plain sailing. The direction of global growth is probably downwards this year, and with the US central bank selling back the bonds it acquired under quantitative easing, market volatility is likely to pick up further. The data still shows no acceleration in inflation. As such, if and when economic and market conditions get tougher, at least one of those four rises looks vulnerable.
Does the debate around four versus three rate rises actually matter? We would argue no. In terms of US and global economic growth, two hikes in 2018 isn’t that much different from three or four hikes. In that sense, Fed hikes were never our worry for growth and risk assets this year. We were more concerned about a sudden rise in the oil price, or a harder landing in China. Moreover, we might be looking in the wrong place for tighter monetary conditions – the Fed’s balance sheet reduction, or quantitative tightening, combined with higher US Treasury issuance, has greater potential to put upwards pressure on longer-dated bond yields. This could be what really spooks markets and there wouldn’t be much the Fed could do about it. Except, of course, not hike four times.
