Prophets

How the Fed's Rate Hikes Might Play Out

The outlook is for three increases -- though not the way market may be anticipating.

Going up.

Photographer: Justin Sullivan/Bloomberg

The U.S. economy is poised to deliver on the Federal Reserve’s economic forecast for this year. That means a baseline outlook for three interest-rate increases remains in play -- though not the way market may be anticipating. Think of it as two rate hikes, one each in June and December, with an option for a third in September.

The data continue to be generally supportive of the economic forecasts outlined in the Fed’s December Summary of Economic Projections. The first employment report of the year set the stage with a solid jobs gain but an uptick in unemployment. The latter indicates that there remains slack in the labor market, and Fed Chair Janet Yellen would like to let the economy run strong enough to squeeze it out.

Surveys of manufacturing and nonmanufacturing activity also point toward firming activity. In addition, housing starts and permits remained strong in January as December numbers were revised higher. Starts are 10.5 percent above year-ago levels. Housing appears likely to remain resilient given the uptick in mortgage rates experienced late last year as steady jobs growth and rising wages provide underlying support.

Inflation numbers firmed in January, with the core consumer price index gaining 0.3 percent for the month and 2.3 percent from a year earlier. This bodes well for the Fed’s inflation forecast for the year. Moreover, the recent decline in the value of the dollar should help support a move higher in the Fed’s preferred inflation measure toward the 2 percent target.

Altogether, the economy seems to be tracking at a fairly brisk pace. The Atlanta Fed is looking at 2.4 percent annualized growth for the first quarter of 2017, and the New York Fed is at 3.1 percent. Both exceed the Fed’s estimates of potential growth and should push unemployment a bit below the natural rate and inflation up to target per the central bank’s forecast.

So, that begs the question: Is the Fed falling behind the curve on inflation? Not yet. The upward pressure in headline inflation is likely coming to a close. Oil prices reached a low in January 2016, so the base effects are now waning and will continue to do so as long as oil is generally tracking sideways. Similarly, the dollar is now about flat from year-ago levels. Absent further declines it will cease to place upward pressure on inflation and, in the future, favorable year-over-year comparisons suggests some modest downward pressure:

Furthermore, market-based measures of inflation expectations remain historically low:

And while survey-based measures firmed recently, they too remain on the soft side:

And, despite signs that inflation is firming, the recent behavior of the core-PCE index doesn’t suggest inflation is a problem:

The labor market, where measures of underemployment remain high by pre-recession standards, provides further arguments against the notion that the Fed is behind the curve. Wage growth also remains restrained, an additional indication that the economy has room to further expand before hitting full employment.

When the members of the Fed sit down for their March conclave, they will likely conclude that they remain ahead of the curve on inflation and can take a pass on raising rates. They will prefer to squeeze additional gains from the labor market before acting again to tighten policy. And they will take note that they have plenty of time to raise rates later in the year.

If the data turns sharply stronger than anticipated, they can raise rates just six weeks later at the May meeting. And there are some strategic benefits to a move in May. Yellen can prime the markets for a May hike during the March press conference and prove that the Fed can move at meetings without a regularly scheduled news conference, which is more likely to happen anyway if the Fed is changing rates more than once a year.

Most importantly, if data strengthens further and prompts the Fed to pull forward a hike to March or May, markets should reset policy expectations to a baseline of three hikes with an option on a fourth. A move earlier than June suggests a risk that the Fed would be in danger of overshooting its targets without a bit more aggressive action in 2017. And if I am wrong, and the Fed is indeed behind the curve? In that case, markets would be looking at four hikes with an option on a fifth.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Tim Duy at duy@uoregon.edu

    To contact the editor responsible for this story:
    Max Berley at mberley@bloomberg.net

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