Hawkish Fed despite low inflation

Published: Jul 2017

The Fed recently initiated a 0.25% rate hike and announced its intention to start decreasing its balance sheet this year. The latter means the central bank will gradually allow a fixed amount of the assets it owns to roll off. To do this, the Fed will start off by no longer investing the monthly US$10bn of bond repayments. After three months, this amount will increase to US$20bn and to US$40bn three months after that. Another increase will occur later, after which the amount will remain constant. This way, the current Fed balance sheet of about US$4,250bn will halve in about five years’ time. This intended quantitative tightening will have two effects:

  • It will place upward pressure on long-term interest rates.
  • It will remove money from the economic system.

The two effects combined will cause a considerable increase in short-term interest rates. However, the tightening of monetary policy does not stop here as far as the central bank is concerned. Indeed, the Fed intends to raise its rates further, by another 0.25% this year. It will repeat this three more times in 2018 and then another four times in 2019. This is to achieve a Fed Funds Rate of approximately 3% by the end of 2019, the level the central bank regards as neutral – the economy is neither stimulated nor decelerated monetarily.

Is the Fed going too far?

Two issues are very striking:

  • The Fed’s intention amounts to a fairly aggressive method of monetary tightening. However, economic growth has been low and wage increases and inflation have been at persistently low levels recently. Many analysts are therefore wondering why there has been such an about-turn in the Fed’s attitude. Until recently, the mantra of the central bank was “maximum economic stimulus” and consequently it refrained from rate hikes whenever possible. Now this has been reversed to “maximum tightening of monetary policy, unless this proves too heavy a burden on the economy”. Many consider this to be overkill and a policy mistake in the current circumstances.
  • The markets totally disbelieve the Fed and indicate they anticipate that for the time being, growth, wage increases and inflation will remain at levels so low that the Fed will barely be able to raise its rates in practice.
Chart 1: The Fed will tighten monetary policy further and aims to start reducing its US$4trn-plus balance sheet this year

Chart 1: The Fed will tighten monetary policy further and aims to start reducing its US$4trn-plus balance sheet this year

Source: Thomson Reuters/ECR Research

It is not the first time a major discrepancy exists between what the Fed indicates it intends to do and what really happens. The markets are usually proved right in these cases, so it is even more remarkable that the central bank is taking such an opposing stance. What could be the cause of this?

When answering this question, the most obvious step to begin with is to look at what the Fed itself says about this. The central bank first of all believes the recent low levels of growth, wage increases and inflation are, to a large extent, rooted in one-off developments, which will soon blow over. According to the Fed, growth will pick up soon in all likelihood, especially as monetary policy is still very loose, which is stimulating the economy considerably, while the labour market is already tight. This means that if the US economy were to continue to grow by 2% or more, the labour market would tighten further, with substantially higher levels of wage increases therefore no longer being far off, despite all manner of structural forces exerting downward pressure on wage increases. Of course, the central bank could still delay further tightening of monetary policy until all this clearly emerges, but this would run the risk of the Fed suddenly having to hit the monetary decelerator hard, which could easily lead to a recession, the collapse of asset prices and the debt pyramid. Making a start with tightening monetary policy now and proceeding with this at a steady pace seems a safer policy.

Inside information and political games

What could also play a role here in the background is that the Fed might have good indications that Congress will decide upon tax reforms and tax cuts after all by the end of this year/the beginning of next year. Added to this, the White House is, at the time writing, working on a relaxation of rules for banks. These are all elements that could additionally boost growth and could ensure it ends up above 3% for several quarters next year. Given the low increase in the workforce and in productivity, this would lead to a further substantial decline in unemployment. This would therefore basically mean the markets currently have far too negative a view of growth forecasts, at least as far as the interest and capital markets are concerned, because stock markets actually foresee a very favourable future.

An entirely different angle is that the Fed is playing a political game. Indeed, many Fed members will have to step down at the beginning of next year. Combined with the positions that will have to be filled anyway, this will give Trump the opportunity in the Senate – which has to endorse the nominated Fed members – to compose the Fed entirely according to his own preferences. Trump himself has regularly changed opinion in this respect because he initially believed Janet Yellen was causing market bubbles with her low interest rates and high money creation, while he later actually complimented her on keeping rates low.

Nevertheless, there is a large group within Congress that believes the policy of low interest rates and high money creation interferes far too much with free market forces. According to them, this leads to more and more misallocation of capital, which could ultimately catch up with the economy. This group of Congress members intend to appoint new Fed members who will quickly put a stop to high money creation and low interest rates. All predictions of further rate hikes might therefore well be a pretence of the present Fed members seeking to accommodate the views of the hawks in Congress. For the interest rates it makes a huge difference what the right interpretation is.

We believe the first interpretation is the most likely as we think a combination of very easy monetary conditions, increasing purchasing power, possible tax cuts and deregulation will result in higher growth and more upward pressure on inflation in the coming quarters. In itself, the Fed could easily implement its plans for interest rates. However, it should be expecting downward pressure on inflation exerted by oil prices as well as problems in the oil sector, oil-exporting countries and with riskier bonds based on oil prices.

The statements by Fed members are evidence of the fact the central bank is harbouring more and more concerns about share prices rising ever further and declining credit spreads. In this scenario, it will not be long before the onset of bubble formation is evident. This is why we expect the Fed to initiate another rate hike of 0.25 percentage points this year, but probably not until December. The central bank might announce in September it will start downscaling its bond portfolio, but this would not have too many consequences initially, as it would remain restricted to relatively very limited amounts for the time being.

This also means that we see US (and European) long-term interest rates gradually coming under upward pressure and that a ten-year US interest rate of 3.25% in the middle of next year would not surprise us.

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