The easiest part of my analysis of the US Federal Reserve (the Fed) from meetings in San Francisco, New York and Washington is that the path to higher interest rates will be (very) gradual.
The easiest part of my analysis of the US Federal Reserve (the Fed) from meetings in San Francisco, New York and Washington is that the path to higher interest rates will be (very) gradual. My view remains unchanged that the Fed will raise the official Fed Funds target range to 0.5%-0.75% at the December FOMC meeting. Indeed, one Fed watcher I spoke with implied that the Fed would be 'embarrassed' if they did not raise interest rates in December - much as they felt in December 2015.
Going forward, I then expect two rate hikes each year (likely June and December) in 2017, 2018 and 2019 - taking the Fed Funds rate to around 2%-2.25%. Markets have a slightly lower path than this, while the Fed's 'dots' remain more aggressive.
It was highlighted to me that the data on the real economy in 2016 was telling the Fed to be very careful in raising interest rates, because the economy is vulnerable to any tightening of financial conditions - either by higher interest rates and/or a stronger USD. Perhaps a more hawkish interpretation of the 2016 data flow is that the potential economic growth rate for the US has declined to a lower level than expected, say around 1.5%. This would make the case for higher interest rates, but only gradually and not by much.
The other key consideration for the US central bank in 2017 is whether or not there is potential for an easing of fiscal policy through next year and/or a substantially higher USD. This could come in the form of an economic stimulus package from President Clinton if she was to win the election (see Blog 6 for details). The Fed would be very sensitive to these developments.
At this point in time, the consensus is for two rate hikes in 2017 - but from the conversations I have had, there is more risk of 1-2 hikes next year, than there is of 2-3 rate hikes.
The difficult part for the Fed's outlook is what the peak in interest rates is likely to be in this cycle, how this differs from previous cycles and whether targeting inflation at 2% remains the best way for the central bank to help manage the US economy. This, and a number of other issues as detailed below, were of great interest in my meetings in the US.
As evidenced by recent comments from the Fed Chair, Janet Yellen, the overriding view remains that if interest rates are held low for an extended period then the economic recovery in the US will deepen and broaden and this, eventually, will see strength in the labour market translate into an upward trend for wages and inflation. Indeed, the Fed already believes this is beginning to happen, citing statistics such as the Atlanta Fed's wage index and core personal consumption expenditure inflation.
So while opinions within the Fed differ on the exact timing and extent of the rate hikes to come, the view remains clear that a gradual upward path for US interest rates should be expected over coming years.
My expected peak in the Fed Funds rate of 2%-2.25% in late 2019 remains, however, well below the Fed's current long-run rate of 3.0% - as indicated by the 'dot' forecasts in September 2016. However, this long run 'dot' has been trending down for a number of years (from 4%) and I would not be surprised to see further downward move in the months and years ahead.
While this may not occur at the December 2016 FOMC meeting, I would expect the rate hikes in 2017 and 2018 to also include further reductions in the expected long run Fed Funds rate. In this regard. the tightening of monetary policy to come could be seen as 'dovish rate hikes', ie. an increase in the current target rate, but a reduction in the expected long run rate.
It is also very interesting to see the open discussion at the Fed on the level of the neutral level of interest rates in the 'new normal' environment we find ourselves in. In the days prior to the Global Financial Crisis (GFC), the neutral real interest rate was considered to be around 2.5%. Adding in a 2% inflation target implied a neutral nominal interest rate of 4.5%, which gave the Fed plenty of room to cut interest rates to support the economy in any downturn.
Now estimates of the neutral real interest rate, at least in some parts of the Fed, are around 1%(or lower). A 2% inflation target, therefore, gives a neutral nominal rate for the Fed of close to 3% - ie. the current long-term rate assumed by the 'dots'. However, some in the private sector are of the view that the neutral real Fed Funds rate could be even closer to zero, meaning a neutral nominal rate of just 2% - this view is indeed closer to my own.
The concern is that such a low level of real interest rate gives the Fed very limited options to ease monetary policy substantially in an economic downturn (ie. interest rates are already so low in the good times), without having to resort to policy developments such as negative interest rates and/or quantitative easing.
One potential 'solution' to this problem is to have a higher inflation target, say 3.5%-4%, so that a very low neutral real interest rate would still provide a neutral nominal rate of around 4.5%. Over time, this would hold monetary policy 'easier' than otherwise would have been the case, protecting the economy from downside risks (well that is the theory anyway). This idea has been put forward by the very highly regarded President of the San Francisco Federal Reserve, John Williams (*see footnote).
While thinking about the neutral rate of interest and the Fed's inflation target is an interesting concept, it is fair to say that the Fed is a long, long way away from contemplating any change to their inflation target. Nevertheless, it has been stressed to me on this trip and previously (including by the Chicago Fed President, Charlie Evans, when he was in Sydney in October this year), that the Fed's 2% inflation target should be seen as an average and not a ceiling. In this way, the central bank’s inflation target is much more like the Reserve Bank of Australia's flexible '2%-3% average over time' target than it is like the European Central Banks strict 'close to 2% and no higher' inflation target.
Overall, within the Fed there looks to be an appetite to accept some over-shoot on inflation a little above the 2% target. In essence, to ensure inflation expectations are around 2% over the medium-term, some over-shoot may be required to offset the prolonged period of under-shooting the inflation target. In other words, this is supportive of Fed Chair Yellen's ’high pressure economy’ strategy.
I also discussed in my meetings the idea that very low and/or negative interest rates could be counterproductive, especially given their negative impact on savers and the psychology of consumers. Most agreed that this was certainly a concern, especially for consumers and households. But we also agreed that one part of the economy that should not have their confidence to borrow and spend negatively impacted by ultra-low interest rates was the government. And so a much greater use of fiscal policy, ie. government borrowing, to then spend on productivity enhancing infrastructure and other investments, was certainly a part of the economic recovery process that the Fed was looking for. This is, of course, not unique to the US as we have seen similar comments/developments in the UK, Europe, Japan, Canada and Australia.
From my discussions, it does also seem that one area the Fed is worried about, or at least conscious of, is the very low level of bond yields - not just in the US, but around the world. The US central bank is thinking about what would happen to the bond market if the perception ever grew that it was 'behind the curve' in raising interest rates in the context of a higher inflation rate. This does not appear to be much of a risk in the near-term, but it is very pleasing to see that the Fed is aware of the vulnerabilities of the bond market and the interplay between its own actions and those of bond market participants.
While the Fed could not comment directly on the US Election, not surprisingly, one aspect of the election that it is clearly concerned about (as am I) is the trend towards anti-globalisation. This, of course, is not a development unique to the US, but it does seem that the Fed (and most market economists) are concerned about the economic growth implications of a less trade-orientated and less-connected global economy.
A further concern is that the US election could see further grid-lock in Washington and little to no progress on important economic reform issues.
Another interesting development in the way the Fed thinks about the economy is the labour share of GDP v the profit share. For much of the time since theGFC, the profit share of the US economy has been relatively high, while the labour (wages) share has been low. It was pointed out to me that the Fed may be inclined to hold interest rates relatively low in order to strengthen the labour market to the point where the wages share of the economy rises relative to the profit share. This could act to improve the level of income equality - but is unlikely to be welcomed news to share market investors.
Finally, the Fed is also thinking about the economy of the future. What will be the inter-play between technology and economic opportunity? For example, what happens to all the world’s taxi drivers once driverless cars come to dominate? This will likely be a very important issue for those on relatively low-skilled and low-paid work.
So for the Fed, the near-term outlook seems relatively clear - expect a rate hike in December 2016 (unless Trump wins the election and markets respond badly to this) and a very gradual rate hike cycle in the years ahead. The longer-term outlook is less clear. Expect to see further reductions in the long-run Fed Funds target, towards 2%-2.5%, and an ongoing discussion of the neutral interest rate level. Even further out the Fed is thinking about the right target for monetary policy and the policy framework for the economy of the future. While this long-term policy thinking is unlikely to impact financial markets in most investment time horizons, it is pleasing to see that this work has begun. My next Blog will be from Washington and the Presidential election. To say this is a focus of all those I have met in the US would be an understatement - it is all-consuming!
*Footnote
For more on this I recommend you read the research paper, "Monetary Policy in a Low R-star World", August 15, 2016 and the speech, "Whither Inflation Targeting?", September 6, 2016. For a broad perspective on why both US and global interest rates are so low, I also recommend you read a recent speech by the Fed's Vice-Chair, Stanley Fischer, "Why Are Interest Rates So Low? Causes and Implications", October 17, 2016
