Central Bank Policy…2017 Outlook: Fed Still Behind the Curve

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By some measures, the Fed has been behind the curve since mid-2014, in not gradually raising its policy rate.1 Granted the Fed chose to delay initiating its hikes until unemployment fell below its 5% target in Q42015, while maintaining concerns over historically low core inflation. Despite a second quarter-point hike now after a one year pause, the Fed finds itself even further behind the curve than at this time last year. Even under an accommodative rules-based policy rate, December’s rate should be closer to 2-2 1/4 and not 0.75%. As it stands, real policy rates (minus core inflation) are -1%, when full employment and 2% GDP growth would imply a 0.6% neutral real rate as a minimum. If real GDP growth continues above 2.5% as Q4 is trending, then the neutral rate would approach 1%, still significantly below the 2.1% neutral rate average in the 20-yr period up until the GFC.


We think that neutral Fed real rates (FF rate minus PCE deflator) should hover between 0.6% and 1.2% (1stdev of 15 year trend where natural rate r =1.3x g and g has fallen 0.5% over last 10 years) over the next few years. If core inflation creeps up to 2.0% over the next year, from 1.65% now, then the Taylor-rule FF rate target would rise to 2.50%. In addition, CPI is likely to reach 2.3% next year from 1.7% currently, with crude oil alone adding 40bps at current prices. As CPI exceeds core inflation, neutral real rates would likely increase from 0.6% to 1.2% bringing the target FF rate to 3.1% by December 2018. Clearly the risk is on the upside!


Though long-term real rates were negative as recently as Q3CY16, they are now 80bps and should reach 110bps by the end of 2017.2 Should the CPI exceed core inflation by more than 50bps, then we expect term premia to rise from 22 bps now to 100bps+, pushing 10 year treasuries to as high as 4.2% by the end of 2018 (see Chart p.12). In fact, ‘Greenspan’s conundrum’ could very easily end up becoming ‘Yellen’s conundrum’ (if reappointed to a second term), as the market, being significantly ahead of the fed would likely push 10 yr yields to 4% long before the fed finishes ratcheting up its hike path through 2019, ending the current recovery.


Finally, if the Fed drains off $2trn in excess liquidity over the next 4 years (contrary to its current stated intention), real long term rates could rise an additional 60-120bps. However, attractive swap rates (Chart 6) should ensure that overseas demand limits the rise, while demographics will continue to favour strong demand.

Implications

  • The Fed has been leading the central banks’ rate cut race to the bottom and must begin to redress policy rate misalignment (Charts 12, 14)
  • Confusing and contradictory FOMC guidance may call for implementation of rules-based policy rates (p.10)
  • Inflation is likely to pick up faster than current Fed path indicates, leading to a ratcheting up in rate hike forecasts. Expect four quarter-point hikes in 2017 and 2018 (Charts 8, 9)
  • The Fed is likely to see significant intervention from Congress should it not begin draining excess liquidity over the next four years (p.3)
  • Though real long-term rates and term premia should rise over the next few years, demographics and overseas demand to limit the slope (Chart 7)
  • Chair Yellen’s allusions to a return to Greenspan’s ‘high pressure economy’ are misplaced (p.20)
  • Policy rates are like lighter fluid or kindle for a fire; they will help start the fire but this does not provide long-term growth. If anything, excessively low short-term rates
    encourage business to increase leverage and thus volatility as ROA peaks (Chart 15).

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