Fed Hikes, with More Coming; Sees Stronger Economy

As expected the Federal Reserve raised the Fed Funds rate from a range of 1.75%-2.0% to a range of 2.0%-2.25%. The “dot plot” showed that 12 of 16 FOMC members now believe that the Fed Funds rate at the end of 2018 will be in the range of 2.25%-2.50%, strongly implying that another hike in December is very likely.  Financial markets are now pricing in an 80% probability of such a hike. The dot plot also suggested that the FOMC participants anticipate a total of three more hikes in 2019 although financial markets, and EH, anticipate only two. Further projections indicate one more hike in 2020.

The accompanying statement was unchanged from the June meeting except for the fact that one crucial sentence was removed: “The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.” The deletion of that sentence implies that the Fed believes it is now raising rates to the point where they are no longer simulative to the economy, nor do they need to be. Indeed the Fed significantly raised its GDP forecast from 2.8% in June to 3.1% currently, and increased the 2019 forecast from 2.4% to 2.5%. The Fed forecasts also suggest that the Bank may keep interest rates above the so-called “neutral rate”, which is neither simulative nor restrictive, for perhaps as long as two years.  We caution that the neutral rate is an unobservable theoretical rate.

The intent of the rate hike is to fend off incipient inflation, which is showing up in some data, although some observers feel it is only a temporary increase. However the Fed has to worry about inflation a year from now, because it takes that long for rate increases to fully affect the economy.

The increase in the Fed Funds rate has driven rates up for mortgages and other types of loans such as credit cards, auto loans, and commercial and industrial loans. It has also driven up the “short end” of the yield curve more than the long end.  For instance it has driven up 3 month and 2 year yields more than the 10 year yield, flattening the yield curve.  We emphasize that the curve is still positive, and even if inverted, where the 10 year yield becomes higher than the shorter term yields, it would still give us approximately 3-5 quarters warning of a recession.  Therefore a recession in 2019 seems quite unlikely at this point.

There was no mention in the statement of the risks of a trade war. However in a press conference afterward, Chairman Powell said “We've been hearing a rising chorus of concerns from businesses all over the country about disruption of supply chains, materials cost increases… If this, perhaps inadvertently, goes to a place where we have widespread tariffs that remain in place for a long time, a more protectionist world, that's going to be bad for the United States economy….  It's a concern. It's a risk. You could see prices moving up… the tariffs might provide a basis for companies to raise prices in a world they've been very reluctant and unable to raise prices ... We don't see it in the numbers [yet].”