The market is under-pricing the risk that the US Fed will tighten rates more quickly than expected

 
Michael Grady
Federal Reserve Chair Janet Yellen Holds News Conference
While official data was softer in the first quarter, survey indicators remain strong (Source: Getty)

The US Federal Reserve lifted interest rates on 15 March for only the third time since the global financial crisis.

Encouraged by inflation nearing its 2 per cent target, stronger growth, and conditions in the labour market, the Federal Open Market Committee (FOMC) decided to raise the target range for the federal funds rate to between 0.75 per cent and 1 per cent.

Yet the Fed signalled it was in no hurry to quicken the pace of tightening from December’s median projection of three rate rises this year. Market expectations are a little below that guidance, anticipating between two and three quarter-point rate hikes in 2017. But after hiking rates more slowly than anticipated in 2015 and 2016, is the market now underestimating the risk that a complacent Fed could fail to tighten quickly enough?

Read more: Is the US economy ready for higher interest rates?

The fact that the first rate rise this year came earlier than expected – on the back of stronger domestic growth and reduced downside risks to the global economy – is a positive sign. Strengthening domestic and overseas growth seems to have been enough to shift the thinking of many Fed officials on that occasion.

The first estimate for US GDP growth for the first quarter of this year, however, was surprisingly weak, and it may cause some pause for thought on the FOMC. Yet underlying conditions remain robust and should there be more clarity around the Trump administration’s fiscal plans, the risks are tilted towards a somewhat faster pace of rate hikes this year and next.

Looking ahead to 2018, the markets are currently priced for just one rate hike, a pace that is well short of that expected by the Fed itself. That creates opportunity for investors to position for a material repricing, especially in the event of a large fiscal stimulus package being delivered towards the end of this year. If that comes to pass, we would expect the market to price three hikes for 2018 instead, which could be the catalyst for a sell-off in longer-dated yields, perhaps in the region of 50 to 75 basis points.

While the official or “hard” data was softer in the first quarter, survey indicators remain strong. It is difficult to conclude whether the recent boost to US sentiment is driven by the economy or the policies of the Trump administration.

Read more: A House divided: Donald Trump’s entire reform agenda is in serious trouble

Trump seems to have had more of an impact on business, with small companies encouraged by anticipated tax cuts and easing of regulatory requirements. For consumers, increased sentiment is the result of real income growth over the last year, supported by a strong, strengthening labour market and, perhaps, an expectation of income tax cuts. Nominal wage growth is expected to continue to rise steadily, with headline inflation seen easing back a little towards the end of the year. That would mean better prospects for real wage growth towards the end of 2017.

If some elements of the budget are clear ahead of implementation, consumer demand and corporate spending decisions may kick in in anticipation of the change. Arguably some expectation of additional fiscal spending is already being built into investment decisions. The extent to which small companies can bring forward those decisions is limited by the availability of credit, however.

The biggest consideration for the Fed is whether it is already behind the curve and the implications of that position. At this stage, the US central bank does not appear too far behind, as core inflation is not expected to rise dramatically above target over the coming year or so. But the reality is that, with inflation already around target and the economy close to full employment, it is hard to make the case for policy that implies deeply negative real interest rates.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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