Author: Richard Jerram, Chief Economist, Bank of Singapore, Member of OCBC Wealth Panel

In his first testimony to Congress, new Fed Chair Jay Powell showed it will be more of the same under his leadership. Gradual interest rate policy normalisation will continue, alongside a readiness to alter the trajectory depending on the flow of news on the economy. This is textbook central banking.

Powell downplayed the significance of recent market turbulence. He must be keen to avoid any talk of a “Powell put” in case financial markets start to anticipate excessive policy sensitivity to asset price movements.

Powell noted that his personal view of the economy has become more positive since December. This is unsurprising, given the firm data releases and fiscal stimulus announced over the past couple of months.

It raises the question of whether the FOMC will raise its forecasts for growth and inflation at the 20-21 March policy meeting. This seems likely and it would open the way for the Fed to point to four rate hikes this year, rather than the three they signalled at the December meeting. We expect four.

Market expectations have moved a lot in recent months and are already pricing in three rate hikes. As a result, a slightly hawkish tilt by the Fed should not have a dramatic impact, although it could add to upwards pressure on bond yields. As our Head of Investment Strategy Eli Lee has noted, this might increase volatility, but should not be a major threat to equity markets.

Even though Powell’s testimony gave a boost to USD, the currency has been notably unresponsive to rising US interest rate expectations in recent months. Starting from a position of relative USD strength, it seems that the prospect of the start of normalisation elsewhere is a more powerful factor and we see this sending EURUSD to 1.29 by year-end.

The more significant gap in market expectations relates to where the Fed stops hiking, not how quickly it moves. The market sees the Fed Funds rate peaking at around 2.50-2.75%, which is what the Fed sees as a neutral level. At the moment the Fed sees policy rates pushing up to 3.0% in 2020, which implies a mildly tight policy.

However, considering that by 2019 it is likely that the unemployment rate is well-below normal and inflation is above target, the Fed will need to be more aggressive. Interest rates usually need to go well above neutral levels in order to slow down an overheating economy, so it is easy to see the Fed Funds rate at 4.0-5.0% by 2020.

It is still too far out to be a material concern, but the risk of recession in 2020 is rising. Imprudent fiscal stimulus into a mature economy raises the danger of a boom-bust cycle, with the need for fiscal restraint converging with tight monetary policy. This is still well in the future: for the moment, growth prospects look good.