The Fed’s Regime Change
The Fed’s March rate hike represents a significant shift from a halting beginning in its current monetary tightening cycle to one in which it’s now rapidly picking up the pace.
The U.S. Federal Reserve shifted gears at its March 15, 2017, monetary policy meeting, lifting its key Federal funds rate a quarter-point to a 0.75-1.00% range. Although the increase was widely flagged by Fed officials in the weeks leading up to the meeting and broadly priced in by the market, the shift came in the pace of the tightening: its first quarter-point hike in December 2015 was followed by a second identical in size a year later, and the third coming after just three months.
“I think this is a regime change,” said Thornburg Portfolio Manager and CEO Jason Brady. “Although the Fed began to raise rates a couple years ago, it’s been a halting beginning to what is normally a much more consistent cycle.” Significantly, the Fed retained its previous guidance that a total of three hikes are projected for 2017, defying market speculation that had the Fed possibly raising its forecast to four hikes this year.
The market had also been on the lookout for changes in the policy statement, which the Federal Open Market Committee (FOMC) slightly modified by dropping “only” in front of “gradual” in its usual expression that “economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.” It also reiterated that the key rate is “likely to remain, for some time, below levels that are expected to prevail in the longer run.”
In 2017, though, Brady thinks the balance of risks are still skewed to the upside, with more, not fewer increases than currently projected possible. That’s because the Fed’s dual mandate for full employment and stable prices around 2% has just about been met.
Unemployment is running at 4.7%, which most economists consider the targeted level, and wage growth, as measured in average hourly earnings, is approaching 3%. Although the labor participation rate has been inching higher since November 2015, standing at 63% by the end of February, it’s still below its 65.3% four-decade average. That said, the roughly 2% pace of economic growth since the financial crisis is consistent with the 200,000 per-month rate of job creation over the last two years, as baby boomers retire and people previously on the sidelines move back into the labor force, Yellen suggested in remarks to the press following the FOMC statement. She added that the Fed expects further improvement in the labor market.
In its latest projections, the Fed forecast 2.1% growth this year, identical to its December projection, along with 2.1% next year, up from 2% at its last meeting, and kept its 2019 and longer-run forecasts of 1.9% and 1.8%, respectively. It continues to expect 4.5% unemployment this year and over the next two, as well as a longer-run 4.7% joblessness rate. Its preferred personal consumption expenditure (PCE) inflation index projections were all unchanged, at 1.9% this year, and 2% over the next two and longer-run. As for the long-term federal funds rate, 3% remains the target.
But core PCE (excluding volatile food and energy prices) has been rising since late 2015, and inflation isn’t just a growing issue in the U.S. “The inflation uptick both here and abroad is real,” Brady points out. “China’s producer price index turned positive last August after being notably negative for more than five years,” Brady noted. The euro zone exited deflation nearly a year ago, and last month posted 2% annual inflation. The base effects from low energy commodities prices in early 2016 have been inflationary, though that impact is now ebbing. Nonetheless, Brady said inflation is a “significant risk on the horizon,” adding that if both it and wage pressures increase, the Fed could continue to hike in earnest.
Yellen, in her press remarks, said she thinks there’s scope for wages to increase further as the labor market continues to tighten. But the Fed will remain focused on its mandate, while considering factors that influence its employment and inflation targets. Interestingly, in its statement, the FOMC referred to its “symmetric” inflation goal, which “is not a ceiling,” Yellen explained, but “a target.” She added: “We’re not shooting for inflation above 2%. But there will be deviations above and below it.”
Questioned about whether the Fed also considers the rise in financial asset prices, particularly equities, given the record highs in U.S. stocks, Yellen affirmed that the FOMC does consider financial conditions in formulating its rate and economic outlooks. High stock prices are likely to boost consumption, she noted. In the credit space, she added, risk spreads, “particularly of lower-grade corporate issuers, have narrowed.” That suggests financial conditions remain accommodative, she said.
Sentiment indicators have been running high amid expectations of faster economic growth on Trump administration plans to cut taxes and boost spending on infrastructure. Yellen noted, though, that the Fed hasn’t yet seen much evidence of changes in spending, including by corporate executives. “Those we talk to have a wait-and-see attitude,” she added. Indeed, Fed commercial bank credit growth data in the four months through February show average monthly percentage increases of just 0.7% from the year-earlier month, while the commercial and industrial lending subset in the same period saw a 0.4% average monthly contraction from the year before.
Asked if she has already met with Treasury Secretary Steven Mnuchin and President Donald Trump, Yellen said she had “good discussions” about the economy and regulatory objectives with Mnuchin, and had in fact met with Trump, “and appreciated that as well.” During the presidential campaign, Trump said he would “most likely” replace Yellen when her terms expires in February 2018 because “she is not a Republican.”
In any event, Yellen noted that risk aversion by households and businesses after the financial crisis continues to linger, though she thinks it will “gradually dissipate over the next few years.” But the longer-run “neutral” interest rate is “likely to remain below levels of previous decades.” She mentioned evidence that the neutral rate “might be close to 1% or a little under that,” consistent with longer-run projections of economic growth at just under 2%, inflation of 2%, and a federal funds rate of 3%.
In the market context, Brady points out that shrinking credit spreads somewhat cushioned the impact of past rising rate cycles, but “I think there’s less room for that” this time around, as spreads are already relatively tight. That’s why Thornburg’s global fixed income and municipal bond portfolios are positioned relatively cautiously, reducing both their interest rate risk and credit exposures. That said, “we believe this is a good environment for investing in multi-sector bonds to help mitigate some kinds of market risks as well as generate interesting returns.”
On the equity side, if inflation does pick up steam, “some sectors are likely to benefit, certainly on a relative basis,” Brady points out. “That would include financials, some of which you’ve begun to see in relative valuations over the last several months.” But rate sensitive sectors, such as utilities, will likely underperform, he adds, both as a result of a higher inflationary outlook and due to valuations.
That could force the Fed to speed up its pace of rate hikes. “Whether it becomes three hikes, four or perhaps more as time goes on is less relevant than the fact that portfolio dynamics have begun to change, really since the middle of last year,” Brady said. “As they accelerate the monetary tightening, it’s important to keep the risk dynamics at top of mind.”