Markets seem to think the Federal Reserve’s recent policy statement and Chair Yellen’s subsequent press conference comments were dovish. This is a misread that I believe will have a meaningful impact on fixed income markets. The big question is whether a Fed that is more hawkish than expected is bearish for bonds or simply presents a relative value play as the yield curve slope changes. Some thoughts below
I already teed this one up last week, after the Yellen presser. Evertyhing pointed to a more hawkish Fed in my view. I wrote that the biggest takeaway was Yellen’s view that there are “good reasons to think the relationship between the slope of the yield curve and the business cycle may have changed.” Moreover, the data were moving in the wrong direction – with Fed projections showing higher growth and lower unemployment than after the September FOMC meeting. Taken together with Chair Yellen’s insistence at the press conference that the things holding down inflation were “transitory”, it was clear that she was telegraphing the Fed’s intention to stay the course irrespective of the slope of the yield curve.
In fact, we saw the exact same policy options at the end of last year — and have ended 2017 with the Fed raising rates just as they said they would. University of Oregon Professor Tim Duy has a post up now pointing this out. And his chart below makes clear that, “the Fed ran a hawkish policy in 2017 relative to changes in the economic forecast”.
If I am reading Tim’s chart correctly, the data say the Fed should have raised its policy rate 50 basis points. Instead they have increased the policy rate by 75 basis points.
Why did this happen? In a nutshell, NAIRU. The Fed is caught up in Phillips Curve thinking because – according to that kind of thinking – the trade-off between inflation and unemployment is supposed to be most acute at this stage in the business cycle. From the Fed’s perspective, the undershoot in inflation has become less worrisome because the unemployment rate has fallen below the level where inflation is supposed to accelerate – the non-accelerating inflation rate of unemployment or NAIRU.
The unemployment rate is now guiding Fed policy much more than inflation. And the Fed expects the unemployment rate to go even lower. What’s more, if you parse out the Fed’s forecasts for unemployment and real GDP growth, the risk for unemployment is to the downside. The only way we get the Fed’s projected 2.5% real GDP growth for 2018 and year-end unemployment of 3.9% is by a whole lot of people coming back into the labor force. Without a migration of hidden unemployed people to active labor force participants, the unemployment rate is going to 3.6 or 3.7% with growth as robust as the Fed projects.
What are the chances that the Fed raises interest rates only twice with the unemployment rate a full percentage point below their stated NAIRU level? I don’t see it. Four rate hikes are more likely in that scenario. And what’s more, Yellen has already told us that she doesn’t see the yield curve as a strong signal here. So we should be aware that it may be disregarded as an indicator of impending economic weakness.
The bottom line is this: The unemployment rate has hit levels that make the Fed uncomfortable. Several Fed officials have said that the Fed needs to act pre-emptively to prevent inflation from rising. And since multiple Fed officials have recently suggested that we are at full employment in the US, the bias at the Fed is clearly toward tightening. With a tightening bias, the Fed will stick to its forecasted rate hikes unless we see significant weakness in economic growth. The only question then is whether inflation does rise and how the yield curve responds.
I believe that the lag between Fed hikes and the impact on the economy means the economy will slow toward mid-year and that the yield curve will flatten. However, if inflation does rise from here, the Fed will be even more aggressive. And then, it’s anyone’s guess what impact this will have on longer-term rates and growth. Stay tuned.