- Markets are priced for the Fed to hike rates next week, and we anticipate the Fed will deliver what the market expects.
- The Fed is hiking rates in response to the significant improvement in the labor market. In addition, the Fed is set to raise rates because its communication strategy has backed the Fed into something of a corner, and anything other than a rate increase would be very difficult to explain.
- We expect the Fed will continue increasing rates in 2016. This expectation is based, in part, on our assessment that the communications strategy has some momentum and will compel the Fed to follow through with at least one more hike at the March meeting, before potentially reevaluating their strategy around mid-year.
- The risks around a Fed mistake are rather low, in our view. A small increase in interest rates is unlikely to have an outsized impact on the economy, the Fed’s broader stance will continue to remain accommodative, and the vulnerabilities in the financial system and real economy are much reduced relative to previous instance when the Fed made a mistake.
The Federal Reserve (Fed) is widely expected to increase interest rates at its meeting next week. The probability of a December hike as implied by the futures market has moved from below 30% in mid-October to nearly 80% as of December 8. (Exhibit 1) Other parts of financial markets have responded as well, including the spread between 5-year and 30-year bonds, 25 basis points (bps) narrower since mid-October, and the US dollar, 3.5% higher since mid-October. With markets now priced for a December hike, anything else from the Fed would risk a volatile market reaction. The Fed likely has no appetite for any such risk and as a consequence we anticipate it will deliver what the market expects next week.
Investors are already looking past the first interest rate increase in 10 years, historic though it may be, and are now asking two questions regarding the morning after: First, what is the Fed going to do in 2016? And second, is the Fed making a mistake? This note addresses both questions, after providing a quick assessment of how the Fed got to this point.
How the Fed Got Here
In our view, the Fed’s hike next week will be motivated by two lines of reasoning, one compelling and the other less so. The first line of reasoning, which we find to be the more compelling one, is that the labor market improvement over the last few years has been substantial. The unemployment rate has fallen from 10% in late 2009 to 5% as of November, with nearly a full percentage point of that drop coming in the last twelve months. Other measures of labor market utilization have also improved, including a significant decline in the broadest measure of unemployment (officially known as “U6”) and multi-decade lows in initial claims for unemployment insurance. While some underutilization likely remains, it seems pretty clear that emergency monetary policy is no longer needed to support the labor market side of the Fed’s mandate. (We’ll return to the inflation side of the mandate below.)
The second, less compelling line of reasoning for the Fed to raise rates next week is that its communication strategy has backed the Fed into something of a corner. In a year that was supposed to be defined by “data dependence,” the Fed has actually engaged in a remarkable amount of forward guidance. The guidance started with the dots, which consistently showed an expectation of rate hikes in 2015, it expanded to direct statements from Fed Chair Janet Yellen, who emphasized on no fewer than four occasions that she personally expected rates to rise “later this year,” and then the guidance finally reached the official statement from the Federal Open Market Committee (FOMC), which said in October that it would consider an interest rate increase “at the next meeting.” In the normally reserved lexicon of central bank communications, these statements are notable for their specificity and forcefulness. As a consequence, it is not surprising that market participants, Western Asset included, came to the conclusion that the Fed had a strong desire to raise interest rates.
The issue is that the Fed had so successfully set expectations for a rate hike in 2015 that it became increasingly difficult to explain any further delays. The following passage from the minutes of the October FOMC meeting makes a similar observation:
A number of participants pointed to various reasons why the Committee should avoid a delay in policy firming. One concern was that such a delay, if the reasons were not well understood by market participants, could increase uncertainty in financial markets and unduly magnify the perceived importance of the beginning of the policy normalization process.
This passage stands out because it suggests that the communications strategy itself has become part of the Fed’s motivation for rate hikes, thereby undermining the Fed’s insistence that rate hikes are “data-dependent.” Having the communications strategy play a role in motivating a hike is very unlikely to have been the goal at the beginning of the year, but nonetheless is where the Fed has ended up.
The 2016 Outlook
The role that communications has played in the Fed’s decision to raise rates influences our outlook for the path of interest rates in 2016. In particular, we think the communication strategy has some momentum, in the sense that now that the Fed has worked so hard to start the rate hiking cycle, it will not lightly reverse course. We therefore expect that the Fed will continue hiking in 2016, with at least one more hike at the March meeting before reconsidering its strategy later in the year.
In justifying the coming rate increase the Fed has made a number of arguments based on its medium-term outlook. The medium-term outlook is sticky—the Fed prizes its ability to look through “noisy” data—such that we don’t expect a material change to the Fed’s medium-term outlook in the coming months. More specifically, even though year-over-year inflation has languished close to zero all year, and even though core PCE inflation is still below 1.5%, the Fed has not wavered from its outlook that inflation will rise to 2% by 2017. Putting aside for the moment whether that forecast will eventually be right or wrong, the Fed’s confidence surrounding its medium-term outlook in the face of such substantial disappointment this year suggests that it is going to take bigger or more prolonged disappointment to prompt a rethink. Simply put, if the continued downside surprise in core inflation and further decline in energy prices experienced through 4Q15 were not enough to force the Fed to reconsider its medium-term outlook, why should anybody expect developments in 1Q16 to be any different? And as long as we expect the Fed to stick with its medium-term outlook at least through March, we should also expect the Fed to follow through with another hike at the March meeting.
Of course, this line of reasoning cannot apply indefinitely. As 2016 proceeds, it will become increasingly clear whether the Fed is right or wrong on its medium-term outlook. We think the risks are tilted toward yet another disappointment. One potential source of disappointment could come from wage inflation. After a somewhat chastening head fake from the wage inflation data in 1Q15, the tone of recent Fed comments on wage inflation has again turned more cautious. (In June New York Federal Reserve President William Dudley called a recent uptick in the Employment Compensation Index “noteworthy,” only to reverse course a few months later and concede that “we have still not seen compelling evidence that a tightening labor market is leading to more rapid labor compensation gains.”)
Caution on the prospects for wage inflation seems appropriate for a number of reasons. Not only has wage inflation failed to pick up all year (Exhibit 2), but also there is a wide number of longer term, secular factors that are continuing to put downward pressure on wage inflation. These secular factors include, but are not limited to, competition from foreign workers, an erosion of manufacturing employment in the US and a reduced real value of the minimum wage. Moreover, there are good reasons to think that a significant amount of slack remains in the labor market, which will further limit upward pressure on wages. Should the combination of secular forces and labor market slack continue to keep wage inflation muted, as they have for the past few years, then the Fed would likely be forced to pause and reconsider the pace of its hiking cycle, perhaps starting around the middle of next year.
Is the Fed Making a Mistake?
Given the inflation outlook discussed above, it will not come as a surprise that Western Asset has some sympathy with the dovish members of the FOMC who view downside risks to inflation as a reason to continue with zero interest rates. However, while we may have slightly different policy preferences, it’s far from clear that the Fed is making a mistake by hiking next week.
The inherent uncertainty around the appropriate level of interest rates is substantial. In fact, data presented recently by Chair Yellen showed that at any given point in history, estimates of the natural level of interest rates have had a range of 400 bps!1 (Exhibit 3) Of course, forecasts of the future natural level of interest rates are subject to even more uncertainty than that. The takeaway from the remarkably wide range of estimates is that it is entirely possible for the Fed to gradually raise rates a few times without having any noticeable effect on economic activity. Anybody who claims that rate hikes of, say, 100 bps will have an outsized economic impact is likely overstating the role that interest rates play in the economy today, not to mention overstating the precision of their own estimates.
Those who are concerned about a mistake also tend to mischaracterize the Fed’s broader stance with regard to monetary policy. The Fed is proceeding very cautiously. Even as it is increasing interest rates, the Fed will maintain the size of its balance sheet at close to $4.5 trillion. In 2016 this policy will require purchases of roughly $225 billion of US Treasuries and $300 billion of agency MBS just to replace the bonds scheduled to mature. The Fed has also been emphatic that it can and will moderate the path of interest rates should growth disappoint, or should new downside risks emerge. The Fed’s decision to delay rate hikes at the September FOMC meeting was evidence of its responsiveness to downside risks (in that case to the heightened risks of a hard landing in China), and as such bolsters its credibility on this point. The combination of still accommodative balance sheet policy and an emphasis on a flexible hiking path are oft-overlooked details that will soften the impact of tightening.
Finally, it’s important to maintain perspective on what constitutes a mistake from the Fed. As has been widely acknowledged, the Fed made a series of mistakes in the run-up to the 2008 crisis by not easing early enough or aggressively enough. The root of the Fed’s mistake was that it did not fully appreciate the risks surrounding the financial system, which was highly leveraged and extremely vulnerable to a decline in house prices. Certainly the risks on this front are dramatically lower today than they were in 2007. Leverage has come down as banks have raised capital and curtailed many forms of risky lending. And the parts of the economy that appear most vulnerable to ongoing shocks (including manufacturing and energy) do not have the same inherent leverage that the housing market had. One consequence of the much reduced leverage in the financial system and in vulnerable sectors of the economy is that even if growth does not meet the Fed’s target in 2016, the consequences of the Fed’s move are likely to be minimal, or at least much less severe than those related to the Fed’s mistake in 2007.
In many ways the morning after next week’s Fed hike will be very similar to the morning before. The Fed will still be guided by a mix of an improving labor market on the one hand and a communications strategy that has emphasized a desire to get off of the zero lower bound on the other hand. Given that mix of motivations, we think the Fed will be compelled to continue hiking in 2016, with at least another hike at the March meeting before perhaps reconsidering mid-year. In terms of consequences, a few Fed hikes over the coming quarters are unlikely to have an outsized economic impact, the broader stance of monetary policy will still be quite accommodative and the risks of the Fed making a significant mistake will remain, in our view, rather muted.
- Chair Yellen defines the natural level of interest rates as “the value of the federal funds rate that would be neither expansionary nor contractionary if the economy were operating near its potential.”