Published On: Sun, Oct 14th, 2018

Market selloff won’t change Federal Reserve’s course to higher interest rates

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All signs suggest the Federal Reserve will not bow to Donald Trump and deviate from the gradual lifting of US interest rates, after the US president declared at the depths of last week’s sharemarket sell-off that the central bank is “out of control”.

Fed policymakers have consistently and more importantly, in an increasingly singular voice, made clear that rates will continue to rise over the course of the next year, and given the strength of the US economy there’s a likelihood that rates will turn at least modestly restrictive.

What’s not yet clear is how far rates will have to rise to reach a level that the Fed considers neutral – where rates neither bolster nor restrain the pace of growth – because rates already have risen so much.

“At present, we are about 100 basis points below the Fed’s estimate of neutral,” RBC Capital Markets chief US economist Tom Porcelli wrote on Friday.

"Now, you have to remember there's a lot of uncertainty about neutral," Mr Evans said in an interview. "We have ...

“Now, you have to remember there’s a lot of uncertainty about neutral,” Mr Evans said in an interview. “We have different opinions about what that is.”

Daniel Acker

“In other words, at this pace of hikes, we will not get to neutral until roughly the end of next year. Not above it – where damage tends to occur. Right at it. Will they go above it? It seems highly likely.”

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The target range for the Fed funds rate is now at 2 per cent to 2.25 per cent. Market bets are pointing to another 25 basis point increase in December.

Fed policymaker projections point to at least three more 25 basis point increases in 2019, reaching 3.1 per cent next year and 3.4 per cent in 2020.

In a blog post late last week, PIMCO market strategist Tony Crescenzi said the neutral rate is “an anchor and not a floor or a ceiling”.

And with rates now within reach of policymaker projections, Mr Crescenzi said “for Treasury yields to move meaningfully from current levels, investors would have to expect either a higher or lower terminal rate”.

‘Moving target’

The yield on the US 10-year Treasury note was 3.16 per cent at the end of trading on Friday in New York, having risen 19 basis points in the last month and 89 basis points in the last year. It has more than doubled since August 2016.

The surge in US bond yields the last few weeks – the 10-year spiked to 3.26 per cent on Wednesday – and last week’s equity sell-off have been attributed in part to a shift in investors’ expectations about just how far the Fed will continue to lift and whether it will accelerate the pace of hikes notwithstanding President Trump’s “loco” characterisation.

Mr Porcelli threw cold water on the Fed over-tightening thesis, arguing that there was nothing new learned on Friday or Thursday about the Fed and its intentions. “Last we checked, the Fed’s dots have changed marginally of late. So did the market just wake up to the reality that the Fed is going to do what they say with regard to the hiking cycle? Actually, we seriously doubt that is what is happening here.”

Recession: a 2020 event?

In an interview with CNBC on Friday, Chicago Fed boss Charles Evans agreed that neutral could be reached with three more 25 basis point increases and then the Fed could continue to lift rates until they became restrictive.

Mr Evans defined restrictive, as he’s said he has previously, “of maybe 50 basis points” above neutral.

“Now, you have to remember there’s a lot of uncertainty about neutral,” Mr Evans said. “We have different opinions about what that is.”

Mr Evans also said: “We might have to sort of feel our way around that a little bit, but I’m going to be looking at how inflation is performing and the momentum in the economy.”

Mr Porcelli said that the Fed tends to lift rates about 100 basis points “above” neutral. It is usually at that point that recession occurs. Based on the Fed’s dot plot, that would be a 2020 event.

‘Not emotional enough’

But here is the problem, the RBC economist said, trend rates of growth, really the key input that helps define neutral, are on the rise. “And the non-partisan CBO has also marked up potential growth for the years ahead. So guess what is likely to happen? The neutral rate is also going to rise.”

This week investors will parse the minutes from the Fed’s September policy meeting where it dropped the word “accommodative” from its description of monetary policy. Perhaps the minutes will provide a reason to tap into some emotion.

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