US Interest Rate Outlook
With Friday’s Bureau of Labour Statistics report that the year over year inflation rate had jumped to 2.5% the debate has begun over the likelihood of a March Fed rate hike. Just the day before, in her 14 February testimony to Congress, Janet Yellen testified that it would be unwise to wait too long to increase rates and signaled the possibility that there could be 3 rate hikes to come in 2017. Yellen stated that she expected the economy to continue to expand at a moderate pace, with the job market strengthening somewhat further and inflation gradually rising to 2%.
Recall that the Fed’s own criteria set out in 2012 was an unemployment rate of below 6.5%, which it reached in 2014, and inflation expectations above 2.5%, which is now no longer an expectation, but a reality. Now, with the second longest economic expansion in US history, rising inflation, low unemployment, and an indication from the current Federal Reserve Chair that waiting too long would be unwise, it should be a slam dunk that the Fed funds rate will be increased. Apparently though, it’s not. What then could possibly be the excuse for the Fed not to raise rates in March?
The answer to this question lies in the yield curve. Having interfered in the bond market with successive quantitative easing (QE) programs the Fed now has taken ownership of the entire yield curve. Previously, the long end of the curve was determined by market forces exclusively. Now, increasing the Fed funds rate will raise rates at the short end and without a corresponding unwinding of QE, the result would be a flattening or inversion of the yield curve, with the accompanying risks to economic destabilization.
Therefore, the proper question to be asking is will the Fed implement a policy approach that lifts the entire yield curve? And if not, why not, if everything really is as awesome in the economy as we are told repeatedly? Maybe everything isn’t so awesome after all?
- With a $20 trillion national debt (which does not included the unfunded liabilities of Social Security and Medicaid), every 1% increase in bond yields will result in an additional $200 billion in debt service charges.
- Increasing long yields would prick the housing bubble (again) and the stock market bubble.
- Even with the bond and stock markets at all time highs, public pension funds are seriously underfunded – the Dallas Police pension fund being the poster child for pension mismanagement. The risk of social unrest resulting from bankrupt pensions should not be underestimated and bailing them out, if even legal, would put even more pressure on the public debt.
- The $1 trillion from the Donald Trump’s corporate profit repatriation “plan” that everyone is so giddy about will likely disappear into the black hole of government debt.
Notwithstanding Yellen’s warning that waiting too long to raise rates would be problematic, do not expect 3 rate hikes in 2017, or at least ones that are sustained. In the unlikely event that 3 rate hikes are carried out, they would likely be revoked in short order due to a destabilized economy or markets or both.
Just like 2016 when the consensus opinion of multiple rate hikes were not implemented, expect more double speak in the form of hawkish tones while doing nothing. The excuses for not moving, of course, will bring back memories such as 2016’s Brexit vote excuse. Expect more excuses of a similar nature – perhaps European instability, French, German (and Italian?) elections, China, or everyone’s favourite bogeyman, the Russians!
But with rising inflation thresholds now being breached, the Fed cannot delay interest rate hikes any longer. And with the associated economic risks with raising the interest rates along the entire yield curve, neither can the Fed raise rates. In short, they are boxed in.
It is my opinion however, that they will likely err on the side of risking rising inflation while trying to mask its revival, continuing with their hawkish public pronouncements, but really doing nothing. With no real policy tools left at their disposal, their plan has really come down to hoping that the US economy really does grow into the awesomeness that will give them opportunity to implement interest rate normalization.