My colleague Steve Blitz sets out why the market is still too complacent with respect to the path of further Fed rate hikes even if our more optimistic view of accelerating capex leading to an extended cycle eventuates.
The attempt to characterise the Fed after Wednesday’s FOMC statement as a hawk or a dove misses the point. It is neither. The FOMC is simply stating that it has officially adopted the position that policy rates no longer need remain low to support growth. Rather, rates need to rise to be consistent with an expanding economy (business and household spending), tight labour markets and inflation running “near the symmetric 2 percent objective” – inflation is no longer expected just to get to the target. It is therefore no surprise that, as long as the economy grows as anticipated, the Fed remains on track for 25bp increases in the funds rate each quarter – our call since last year.
The Fed’s outlook continues to embody its own cycle. The funds rate is presumed to get to 3.4% by the end of 2020 and then settle back to the Fed’s longer-run target of 2.9%. What adjusts through the next several years is not inflation, which remains a remarkably consistent 2.1% throughout, but the unemployment rate. After dropping to a low of 3.6% from the current 3.8%, it rises to the longer-term median of 4.5%. In other words, Fed policymakers really aren’t too comfortable with labour markets running as tight as they are now and believe they can, in the next several years, manage to adjust policy rates such that growth continues, inflation remains unwavering and the unemployment rate drifts up.
While the Fed can be applauded for officially abandoning the fantasy that extraordinary policy measures are still needed to bolster growth, this longer-run scenario is a bit far-fetched. On the other hand, markets still do not believe the Fed will even hit its 3.4% policy rate target. Based on the federal funds rate futures contract two years out, they see 2.7% as the high-water mark. This view is less about the Fed’s intentions, as these bets were placed when Janet Yellen was running the monetary show, and more about a sense that the economy just isn’t going to develop sufficient strength to warrant such rates. Based on the economy’s recent performance, the market is more likely to end up being mispriced.
From the data we look at, there is every reason to believe the economy will more than justify the Fed’s proposed trajectory for policy rates. The question is whether nominal growth will be generated more from inflation than from a real expansion of activity. The answer lies in how much capital spending increases. If capex takes off - and tax changes are now in place to provide a tailwind - then the expansion could very well lead to an endogenous rise in real rates.
That would add a few more years to this cycle and quite a few more basis points to the cyclical top for the funds rate. If such flights of our own fancy fail to lift off, then the Fed’s own cycle is more likely to play out, but with inflation accelerating closer to 3% before all is said and done. It will certainly not mark time around 2.1%.
The mixed bag of inflation and capital spending is illustrated in a way by the tight relationship between the rise in the percentage of the workforce aged 25-34 and the cost of shelter. Shelter is the main driver of CPI inflation, as goods inflation remains fairly flat excluding oil and service inflation comes mostly from rent. At the same time, rising rent is a price signal that has triggered a surge in construction of multi-family homes since the recovery began.
In a further indication that the goods sector has recovered from its 2015-16 slump, the PPI for transport services is back above its 2014 high while wholesale prices for capital equipment for manufacturers have begun to accelerate. Adding to the inflation story, margins for wholesalers and retailers continue to climb (the PPI for trade services), which is indicative of some return of pricing power. As to striking a balance between adding workers or capital, the most recent survey of small businesses indicates a tendency to hire fewer workers while capex plans remain steady.
What this all sums to is an economy continuing to expand with a nascent upturn in capital spending that could evolve into a more forceful cycle. Even if it doesn’t, everything is set for inflation to turn nastier than the Fed’s milquetoast forecast. Either way, the trajectory for higher policy rates is in place. The market’s “bet” against that happening is what looks wrong.
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