9 July 2018
Johann Jooste, Chief Investment Officer, Bank of Singapore, Member of OCBC Wealth Panel
We think the US Federal Reserve will raise interest rates faster and further than it currently indicates and more than financial markets expect.
Inflation should rise faster than predicted
We expect a rate hike each quarter until at least the end of 2019 (six hikes), whereas the Fed’s dot chart points to five and the market is discounting three.
One reason is that the Fed is already well behind the curve; interest rates are about 1 per cent lower than you would normally expect for this point in the cycle. When there are exceptional downside risks – such as the threat from deflation in recent years – it makes sense to err on the side of caution when tightening policy. However, now that inflation is back to target and unemployment is at a 50-year low there is no longer a need for restraint.
The second reason is that the Fed’s economic forecasts, which are behind its interest rate projections, do not make much sense. Of course there are uncertainties in any forecast; growth might disappoint, or some shock might alter the pace of inflation.
However, the forecasts should be internally consistent.
The Fed’s GDP forecast looks reasonable, as fiscal stimulus should keep growth above the long-run potential until at least 2019 and maybe into 2020. However, above-trend growth always means that the unemployment rate falls. In some ways, that is the definition of above-trend growth: supply conditions tighten.
Unemployment likely to fall more than the Fed expects
However, the Fed does not see the jobless rate falling below 3.5 per cent. Over the past three years, GDP growth averaged 2.2 per cent and the unemployment rate fell by 1.6 percentage points. The Fed thinks GDP will average 2.4 per cent in 2018-2020, but the unemployment rate will fall only 0.6 percentage points (and we have already seen half of that). Unemployment is likely to fall by more than the Fed expects.
Then there is the concept of NAIRU. This stands for non-accelerating inflation rate of unemployment, and is the economists’ term for full employment. If the jobless rate is above NAIRU you expect inflation to slow down, and if it is below then inflation should pick up. Of course we don’t know exactly the level of NAIRU, but the Fed thinks it is 4.5 per cent.
It follows that forecasting unemployment falling to 3.5 per cent means you must also forecast accelerating inflation. That is what NAIRU means. However, the Fed sees inflation steady at 2.1 per cent from the end of 2018 through to the end of 2020 (it is currently 2.0 per cent).
A more probable (and more consistent) forecast would have the jobless rate falling further and the inflation rate steadily accelerating. This would also mean that interest rates would need to rise faster and further than the Fed currently plans.
It is hard to imagine the Fed making radical changes to its forecasts over the coming year.
More likely is that unemployment continues to fall, inflation continues to rise and the Fed raises rates each quarter. Inconsistencies in the forecasts will remain and that will enable the Fed to avoid scaring financial markets.
Of course trade friction could interrupt the process, but that would be because it casts doubt on the GDP growth forecast, not because it resolves the basic inconsistencies.
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