14 December 2017
As wholly expected by the market, the Federal Reserve raised interest rates by 0.25 per cent at the December 2017 meeting. The Fed Funds Target Rate is now in a range of 1.25 - 1.5 per cent.
Actually until it was broadcast a few weeks ago, I had niggling doubts that the Fed would raise at this meeting. Never before has the Fed paused during a tightening cycle, and since it skipped a rate rise at the September meeting I had a doubts that the Fed would raise again today.
Not only is this a more gradual US rate rise than ever before, it’s also the most staccato. Nevertheless, it causes me to doubt how many more rate rises are possible in 2018.
The FOMC statement was virtually identical to the November one. Those looking for a hawkish tilt will note that the sentence on job gains was made more positive. However, perhaps the most significant element in the statement was that two FOMC members dissented, preferring to keep rates unchanged.
Although many market commentators thought there might be a reduction in the projected number of interest rate rises as inferred from the ‘dot plot’, the FOMC participants continue to believe that there will be three rate rises during 2018. That looks a stretch to me.
The Fed did markedly increases its outlook for economic growth in 2018 (from 2.1 to 2.5 per cent) and upwardly adjusted growth for 2019 and 2020 too. It also decreased its estimate of unemployment in 2018 (from 4.1 to 3.9 per cent) and made similar downward adjustments for 2019 an 2020.
Yet the Fed has left its inflation projection unchanged at 1.9 per cent for 2018. That’s a bit of a paradox and one that Yellen didn’t answer well in the journalist Q&A session.
All told, it was a benign meeting. The moderate depreciation of the dollar and drop in US yields since the announcement seems a fair reflection of the fractionally dovish taste left by the two dissenters. However, in a bigger picture sense, the Q&A session was really quite interesting: tax, bitcoins, yield curve behaviour, equity valuations, female economists were all covered. I’ll summarise them here:
Tax: the Fed has factored in the potential tax reform in its economic assessment. However, Fed members have expected this for some months and thus there is no material change in the current projections owing to the recent developments. Yellen did say that she was concerned that when the baby boomers have retired the US will have a potentially unsustainably high debt-to-GDP ratio and therefore she was concerned about this type of tax reform more generally.
Inflation: Yellen said the item she’ll be leaving unfinished (given that she leaves the Fed in February) was not being able to get inflation back to target. This remained an important objective for the Fed. She felt the inflation softness was due to transitory factors but she noted that the Fed’s understanding of inflation is imperfect. However Yellen said there had been no discussion at the Fed to change the 2 per cent target.
Wage growth: Yellen believes the persistent low wage growth we’ve experienced is due to low productivity. The Fed does expect wages to rise given the tightness of the labour market and that will come from the economic recovery, not the tax reform. She’s pleased that the tight labour market is forcing companies to train imperfect workers which will improve the capital stock.
Stock market valuation: The Fed had observed that the equity market has increased significantly in 2018 and now views asset prices are elevated, as measured by PE ratios. However, Yellen said economists are not good at assessing equity value. She said the Fed have no flashing red, or even orange, warning lights regarding financial market stability. Importantly, she did say that the monetary policy has supported higher equity valuations. For anyone involved in strategic asset allocation, this is a strong statement that the equity risk premium is a function of the interest rate.
Interest rate rises: Yellen is happy with the state of this tightening cycle, saying that leaving it too late would require fast rate rises later which would jeopardise a recovery (a point the ECB should heed). She expects a continuation of the gradual rate rising cycle. Yes, only four more are needed to reach the Fed’s neutral rate, but the Fed expects that neutral rate to raise over time; implying more than another percent of further rate rises in this cycle. However, the neutral rate would not be as high in the future as it was in the past - the Fed too believes in a new normal. That puts our neutral estimate of 3.25 per cent close to the Fed’s.
Balance sheet unwind: the Fed will no longer make comment on the balance sheet unwind, such is its irrelevant to monetary policy in the eyes of the Fed.
Bitcoin: Yellen noted that bitcoins are not legal tender, an unstable store of value and a very small part of the payment system. Whilst the Fed has given no directives to banks regarding bitcoins, it does expect banks to honour their responsibilities, such as anti-money laundering, in bitcoin transactions just as in any other monetary realm. She was asked if the Fed had considered bitcoins as a currency (as stated by NY Fed Chair Dudley) which she refuted, saying Dudley has talked about a digital currency, which was to be distinguished from crypto currencies such as bitcoin. Apparently many of the global central banks are discussing digital currencies, but the Fed are not focussing on bitcoins other than ensuring it isn’t being used for money laundering purposes.
The yield curve: highly unusually, Yellen made some detailed remarks about the yield curve in the future. She felt that the term premium (the extra yield on a government bond in addition to the future average expected interest rate) which has historically been positive is now close to zero, and that she expects that to continue into the future. Therefore yield curves are likely to be flatter in the future. She said the relationship between yield curve slope and business cycle may have changed, and that going forward the market should not interpret a yield curve inversion as an indication of a material reduction in interest rates.
Women and minorities: In response to a couple of questions, Yellen was keen to see a more diverse work force at the Fed. An aspiration didn’t guarantee such diversity; indeed she is the first female Fed chair. Nevertheless diversity is an important function of the workplace. She noted that her bigger concern was the small number of female economists, especially those being trained. Only 30 per cent of current economics students are female.
We’re getting close to crunch time. I have for several years now been arguing that it’s negative real short rates that have driven investors to riskier assets - the so-called reach-for-yield. If there is a bubble in asset prices, my sense is that the arrival of interest rates higher than inflation could, if anything can, prick it. That doesn’t mean a crash; the bubble deflation could be over an extended period.
The single key driver of this outcome now is inflation. It’s a whole separate topic as to why we aren’t getting any inflation, but the fact is we aren’t - further supported by Wednesday’s sluggish core CPI print. Consequently, I don’t think the Fed will be able to deliver the rate rise increases it has in its dot plot. Neither does the market which believes the Fed will do two of the three projected rises in 2018. For me, even two hikes will be a struggle in 2018. That makes bond duration seem cheap at current prices and, given it’ll help mitigate the risk of an equity drop, I do think it’s worth keeping some US duration in a balanced portfolio.
If the first of these three rate rises in 2018 takes place it’ll likely be at the March meeting. That makes it a difficult meeting to chair unless inflation picks up. Yet how much more difficult to chair would it be if the Fed chose to stay on hold at that meeting, thereby giving the appearance of reaching the end of this rate rising cycle? Powell’s first meeting as Fed Chair will be a baptism of fire, I fear.
I share Yellen’s concern on female economics students, and would state my similar experience in the quant subjects more broadly. Yellen said she hasn’t planned her future after she steps down, but it would be great if she could encourage more women into these types of sciences at University and in time into quant roles in the industry. In both a positive and negative sense, Yellen has been a different sort of Fed chair to her predecessors, but isn’t that the point of diversity? I’m sorry to see her go.
Opinions expressed are as of December 2017 and may change as subsequent conditions vary.
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