Five Fed Rate Hikes in 2018 Isn't A Crazy Idea
I focus on the U.S. employment data most of the time, since it is among the broadest and most accurate of the economic indicators on the health of the economy. But it has been eclipsed in importance at this stage of the business cycle by every available measure of inflation pressures.
Interest rates can remain low only if inflation data remain benign, but that’s no longer likely. Economic conditions are ripe -- even overripe -- for inflation to accelerate. It’s becoming clearer that the Federal Reserve needs to increase interest rates more quickly now to avoid being forced to play catch-up later and risk a surge in rates that threatens to push the economy over the edge and into recession. Four rate hikes seem likely this year, but more are possible and probably desirable.
At 4.1 percent, the unemployment rate indicates that labor has become scarce. This conclusion is reinforced by every other labor market measure ranging from job openings, quit rates, weekly unemployment insurance filings, and surveys that indicate that workers now believe jobs are easy to find. If labor is scarce, there is every reason to expect rising wage inflation. And since labor represents the lion’s share of the cost of supplying goods and services, any material rise in wage inflation is likely to be transmitted to price inflation. Only the timing of this process is uncertain at this point.
The modest rise in price inflation seen so far, which is still below the Fed’s 2 percent target for the Personal Consumption Expenditure deflator, only implies the transmission process is taking a bit longer than some expect. Although economic theory is incapable of informing us on the timing of the transmission process, it is wishful thinking to believe inflation will not worsen because it hasn’t worsened yet. Unless the laws of supply and demand have been repealed, the tightening labor market will inevitably produce faster inflation.
Despite recent increases, yields on U.S. Treasury securities provide a negative return after adjusting for taxes and inflation. Buyers of Treasuries are not investing, but rather making annual donations to the U.S. government. Historically, 10-year Treasuries have averaged about 250 basis points above inflation, which implies a 4.5 percent yield given the Fed’s inflation target. So even after the sizable declines in recent weeks that pushed yields up to about 2.90 percent, bond prices are likely to drop significantly further.
All of this elevates the importance of the inflation data. If it continues to accelerate, as was just revealed for January by the consumer and producer price reports, it will become clearer that rates are too low and monetary policy is overly accommodative. If the Fed moves slowly in 2018, it will have to play catch-up at some point, which implies a sharper rise in rates later that could tip the economy into recession. Since that’s undesirable, it would be better for the Fed to increase the pace of its rate hikes to moderate economic growth to contain those brewing inflation pressures.
More or faster rate hikes set the Fed on a collision course with fiscal policy. But that would happen anyway, since a failure of the Fed to normalize rates promptly would result in the market doing it for the central bank by driving up bond yields in response to faster inflation. The portion of the recently enacted tax bill designed to promote investment and eliminate badly designed incentives can help relieve some of these inflation pressures, by increasing productivity and reducing costs. But the more stimulative deficit spending parts of the tax bill add to inflation pressures and worsen the Fed’s predicament.
The Fed has projected three rate hikes of 25 basis points each in 2018. Investors finally seem to be grasping the risks of inflation and are driving up bond yields in response. The Fed needs to hike rates more quickly now to keep inflation in check and limit the rise in bond yields. Otherwise, it will risk undermining the expansion with more aggressive catch-up rate hikes down the road.
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