The consensus view is that the Fed will announce an increase in the Fed Funds rate range by a quarter percentage point when it releases its statement tomorrow. So now the question is about the forward guidance and the economic outlook provided in the policy statement. At this juncture, I don’t expect big changes. I expect the Fed to be more upbeat, but I do not expect it to change guidance. Some thoughts below
Looking for a Goldilocks hike cycle
Let’s look at why this matters. Right now, the US economy is doing well. Indeed, it is doing well enough that the Fed thinks it can gradually raise rates without derailing economic momentum. But the worry is twofold.
Given how late in the economic cycle this rate hike train is occurring, the biggest worry is that the Fed causes the next recession. That’s what all the fuss about yield curve inversion is all about. The yield curve last inverted in 2006 and 2007, just before a recession. And, of course it also inverted in 2000 and before each prior recession in the fiat currency era.
But there is another group of folks that is worried the Fed is behind the curve because asset prices are so high. They believe the Fed has created a credit cycle that is so well-advanced now that trying to prevent overheating will cause a default wave that brings the credit cycle and the economy crashing down. Inflation is a concern with this group, but less so. The real worry is about signs of excess in credit markets and in asset markets.
So the Fed is trying to navigate a path between these two Scylla and Charybdis outcomes. It is looking to raise rates at a pace well-measured enough to keep economic momentum going without allowing inflation or the credit cycle to derail the economy. So far the Fed has been successful.
The yield curve inversion signal
But, of course, the flattening of the yield curve tells you what the sentiment is. The Fed is raising rates without having an appreciable impact on long-term Treasury rates. That tells you that markets don’t think the rate hikes can continue much longer before the Fed is forced to stop — or even backpedal.
The Fed is looking at this signal but trying to push its policy to the max. It says it is aware that flattening is a signal of tightening. But the Fed believes that even if the curve inverts and long-term rates are lower than short-term, it may not be overtightening. It could be that people just have a huge need for long-dated safe assets. So the Fed might just push a bit harder going forward.
Right now, we’re still above 40 basis points between the 2-year Treasury and the 10-year. That’s below my 50 basis point worry line. But it’s at a level where we have to worry about recession right around the corner. And the macro data tell us that.
Signals to look for
So what I am looking for is three things:
- First, I want to see what the Fed says about the economy, particularly the unemployment rate. I am less concerned about how it talks about inflation. I see the unemployment rate as the big motivating factor for timetable acceleration. The headline rate is so low now that Fed policy will be very much dictated by how much it falls going forward. We have already reached the Fed’s predicted year-end level. So, let’s see how the Fed talks about this.
- Second, I want to see how the Fed talks about its balance sheet. Markets have become fixated on the yield curve and interest rate hikes. I think we have reached a point where the Fed might feel it better to throw some of its weight behind balance sheet measures instead. This would take some of the pressure off of rate policy but still signal tightening. I would like to see how the Fed talks about this — if it does so at all.
- Third, there’s the fourth rate hike. I really do not expect a change in forward guidance. But legitimately, the Fed could accelerate its rate hike timetable for 2018 or for the years beyond. If it does, I believe markets would react aggressively and the yield curve would flatten. My expectation is that the Fed wants to keep its options open. And, therefore, it won’t make any guidance changes until it’s absolutely clear. That will only be after the third rate hike. And the fed will be sensitive to the midterms in talking about policy stance changes at that time as well.
So, watch the Fed’s summary of economic projections (SEP). We are now at a stage where policy is much more path-dependent. If the economy is doing well, expect the Fed to be more restrictive than if the data are soft. Pay particular attention to the unemployment numbers. If they drop further from here, it will embolden the Fed to be more aggressive.
My expectation is for the Fed to raise rates, keep guidance the same but be slightly more hawkish. In the coming weeks, we will see if this combination pushes us toward the 25 basis point flattening I have been predicting.