Happy Holidays: Fed wraps up 2017 with another rate hike
The decision was widely anticipated by economists1 and fixed income investors.2 As such, the market’s reaction to the news today was relatively muted—as of 12 p.m. Pacific time, the S&P 500® Index is up 0.2% and the 10-year Treasury yield is little changed.
After a wobbly start in 2015 and 2016, the Fed found a rhythm to its policymaking this year—delivering a tightening announcement at each of its key quarterly press conference meetings (three rate hikes and the start of balance sheet normalisation). Will the Fed be able to deliver four more hikes in 2018? Maybe. In our view, it comes down to three key issues.
First and foremost is the macro outlook. 2017 was a strong year for the global economy. The J.P. Morgan Global Manufacturing PMI™ hit an 81-month high in November, exhibiting some of the strongest economic conditions for the expansion thus far. And this global strength has rippled back into the U.S. in a positive way—taking pressure off the dollar, boosting domestic manufacturing and trade, and providing a tailwind for the earnings of large, multinational U.S. businesses. At Russell Investments, we expect global conditions to remain healthy in 2018.
Domestic hiring has been strong, too. The U.S. unemployment rate currently stands at a 17-year low of 4.1%.3 And, by almost every measure, the labour market is now moving beyond full employment. That’s mission accomplished for the full employment pillar of the Fed’s dual mandate, and our outlook for payrolls suggests we’ll see even more labour market tightening in 2018.
The big wildcard is inflation. Core personal consumption expenditure (PCE) inflation is still well below the Fed’s 2% target. The Fed has written off this inflation soft patch as a transitory blip. If this weakness persists into next year, the Fed will be forced to slow down. We know that technological change and intense competition have been dampening pricing power in several industries. While we recognise these forces, we are forecasting inflation to turn modestly higher in 2018. This view is predicated on two things:
- The trade-weighted U.S. dollar has depreciated more than 8% year-to-date4, which should lift import prices materially next year; and
- We are approaching an extreme level of labour market tightness that is likely to exert upward pressure on wages.
- Changes in Fed leadership
We believe that the significant uncertainty surrounding what the Fed leadership will look like next year could also impact their decisions. Current Chair Janet Yellen has already announced that she will step down from the Board as soon as Jerome Powell’s appointment as the next chair has been completed. Vice Chair Stanley Fischer resigned in October. And New York Fed President William Dudley recently announced that he will resign in mid-2018. These are the three most influential policy positions in the Federal Reserve System and they are all turning over in the next six months. It’s hard for us to have confidence in what the Fed’s decisions are going to look like when we don’t know who the decision-makers are going to be.
In the near-term, we aren’t particularly worried about Jerome Powell’s leadership, as his desired policy approach looks very similar to Janet Yellen’s. After all, he has not dissented from a single Fed vote in his five years as a governor, and his public statements have always been very closely aligned with that of Ben Bernanke (at the time) and Janet Yellen (more recently). However, because Powell is not a trained economist, we’ll pay very close attention to who President Trump nominates to the vice chair post. This individual could prove to be very influential if the economy encounters turbulence in the months or years ahead.
- Neutral rate ambiguity
Last but not least, we believe the uncertainty surrounding the level of the neutral rate of interest will also factor into how many rate hikes the Fed follows through on. The neutral rate is the point where Fed policy pivots from being accommodative to outright restrictive and a hindrance to growth (see our 2018 global market outlook for more on this issue). Most economists (the Fed included) have been ratcheting down their estimates of where the neutral rate is. Translation: even though the federal funds rate is at a historically low level, Fed policy isn’t that accommodative anymore.
For context, one of the models that we look at5 even suggests that today’s hike has already brought us up to the neutral zone. The flattening of the yield curve is sending another warning signal in this regard, as the spread between the 10-year and 2-year Treasury yield has narrowed to just 56 basis points. A few more Fed hikes in 2018 could invert the curve, which would be an ominous signal for investors (and hopefully the Fed, too) given the indicator’s predictive power in forecasting recessions.6
As we get later in the cycle, the dispersion of potential market outcomes widens considerably. In this environment, we believe investors stand to benefit from thinking about the various scenarios that could happen. What we strongly believe is that the Fed is committed to a gradual hiking process. As such, if global growth stays strong and inflation makes a comeback, the Fed is likely to hike four times next year. In our view, this is arguably the best-case scenario—but from a market perspective, Fed hikes are likely to act as a headwind on valuation multiples of the U.S. equity market. We believe investors shouldn't expect returns at anything more than the level of earnings growth in this environment. Risks are skewed towards a slower Fed. But the catalyst is likely to determine the market’s response. If growth remains strong but the inflation soft patch persists, 2018 could see a blow-off rally with particularly strong performance across emerging market equities and debt. A significant downside surprise on the global economy could also slow the Fed down, but this would likely be a much uglier scenario for markets.
We believe the Fed is unlikely to hike more than four times in 2018. Tightening once per quarter is the gradual rhythm that the Fed intended back in 2015 when they kicked off the tightening cycle—and it’s what the Fed has effectively delivered this year. But 2017 was a strong year for global growth and markets, and risks are skewed to a slower Fed. Taking account of the potential adverse scenarios to growth and inflation, our central forecast is for the Fed to only deliver three tightenings next year. In our view, that’s arguably still enough to invert the yield curve toward the end of 2018, setting the stage for an interesting and turbulent period in markets thereafter.
1 Source: http://projects.wsj.com/econforecast/#qa=1510166390855
2 Source: http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
3 Source: https://fred.stlouisfed.org/series/UNRATE
4 Source: Thomson Reuters Datastream
5 Source: https://www.frbsf.org/economic-research/Laubach_Williams_updated_estimates.xlsx
6 Source: Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve Journal of Business and Economic Statistics 27(4), 2009, 492-503 | Williams, Rudebusch