26 March 2018
Author: Richard Jerram, Chief Economist, Bank of Singapore, Member of OCBC Wealth Panel
The latest FOMC meeting appears to confirm that Chair Jay Powell’s Fed will remain dovish. Interest rates will rise slowly, while changes to the outlook will be incremental and reactive. Monetary policy is not set to turn “tight” until 2020, but we think rates will need to rise faster than the Fed suggests.
The Fed put through the sixth 0.25% rate hike of this cycle, as expected, but made relatively small revisions to the “dot plot” or its economic forecasts. By the end of 2020 the Fed sees just over one extra interest rate hike compared to December, which looks like a cautious change considering the fiscal boost that is hitting the economy. In response to that stimulus, growth forecasts have been pushed higher, to 2.7% this year and 2.4% in 2019.
The Fed continues to plan for two more rate hikes this year, although only one more member would need to change their minds for this to become three. We still think there will be three more hikes.
The one relatively hawkish part of the overall projections was raising the terminal rate (ie. where Fed Funds should settle in the long run) from 2.75% to 2.9%. On this basis, interest rates by the end of 2020 will be 0.5% higher than terminal (or neutral) rates, so policy will start to be a drag on economic activity.
Our expectation is that interest rates will go up faster than the Fed expects, and that policy will be tight before the end of 2019. This opens the possibility – certainly only a possibility at this stage – of recession in 2020, especially if fiscal policy is tightening in response to the blow-out in the budget deficit.
It is a little hard to analyse the Fed’s forecasts, because they do not make much sense. Firstly, much stronger growth is (quite reasonably) driving a bigger than previously expected drop in unemployment, taking it almost a full percentage point below neutral levels. However, this is set to have almost no impact on inflation, where the 2019 forecast is unchanged at 2.0% and the 2020 forecast is up just one tenth at 2.1%. Underlying inflation is already running at 2.0% and the lack of response to a strong economy is implausible.
The other uncomfortable aspect of this line of reasoning is that if the responsiveness of unemployment to interest rates is low, and if it takes a big swing in unemployment to have a small impact on inflation (Phillips curve is flat, in economist-speak), then at some point in the future, unemployment will need to rise well above the neutral 4.5% rate in order to bring inflation under control. And it will take a big rise in interest rates to send up unemployment.
Fortunately this is all too far in the future to worry about today. However, we have a basic concern that sending interest rates 0.5% above neutral levels is never enough to cool down an overheating economy. The peak for rates in this cycle is likely to be above 4% or even 5%, compared to the Fed’s 3.4% forecast for end-2020.
In his press conference Chair Powell pointed to a reactive, data-driven approach to policy. This is fine in terms of safe-guarding the recovery, but with the unemployment rate at 4.1% this should be decreasingly important. The problem is that monetary policy works with a lag, and at some point the Fed will need to stop being behind the curve, and take a more forward-looking approach. As a non-economist it is not clear that Powell has the analytical confidence to drive this change, so there is a growing risk of inflation overshoot in 2019-20.
If the Fed is going to stay dovish when the rest of G10 is heading towards tighter policy, then it is hard to see much room for USD to bounce, especially with the need to fund the growing twin deficits. We see EURUSD1.29 in a year.
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