PIG TODAY-Fed Plan for Gradual Rate Hikes Is Starting to Look Complacent

Investors and the Federal Reserve may have grown too comfortable with gradualism — raising interest rates at a pace that is not too fast, not too slow, but just right. The outlook could abruptly shift if global growth gains momentum and U.S. unemployment sinks much lower.

Markets look complacent. Prices in interest-rate futures show almost a 90 percent probability of a hike in June, according to the CME Group in Chicago. While investors have been moving toward another increase by the end of the year, they're not entirely convinced, according to Bloomberg calculations. Volatility has also slumped across different classes of financial assets, with a Merrill Lynch index that gauges options prices on Treasuries is near its lowest levels in data going back to 1988.

The risk, of course, is that when Fed officials release their statement and updated quarterly forecasts at the end of their June 13-14 policy meeting, they'll signal a steeper path of rate hikes than the three annual moves that are currently penciled in for 2017 and 2018.

Boston Fed President Eric Rosengren explicitly took a step in that direction this week, urging his colleagues to raise rates three more times this year, on top of the increase they made in March.

"The risks are shifting in that direction," said Michael Gapen, chief U.S. economist at Barclays Plc. "The bond market is a little complacent about it and is likely taking its cue from wage growth, which remains modest."

Here is the strengthening case for a faster pace.

Take a look at the chart below on Euro-area forecasts. It's not that growth is on fire, but forecasts are starting to get marked up as election risk and other uncertainties fade. The International Monetary Fund forecast in April that global growth would rise to 3.5 percent this year from 3.1 percent last year. A more synchronous global recovery adds a tailwind to the U.S. expansion as export markets strengthen and financial conditions remain easy.

The next chart shows that the real, inflation-adjusted federal funds rate is still negative at a time when the economy has exceeded central bankers' median estimate for full employment and inflation is near their 2 percent target. U.S. unemployment was 4.4 percent last month. Fed officials currently estimate the longer-run sustainable rate is 4.7 percent. Such aggressive stimulus at this stage of the economic cycle is unusual and intentional. Fed Chair Janet Yellen has tried to pull more people back to the labor force by keeping rates low and is also removing accommodation only gradually in an attempt to preserve the expansion.

Yellen and the Federal Open Market Committee are making a big bet that inflation stays in check while they allow the economy to probe the limits of labor market slack. Economists, however, admit that they don't understand inflation dynamics very well, and the committee is wagering that public expectations are strongly anchored around 2 percent. Yet inflation expectations are also influenced by central bank actions.

"They are taking risks here," said former Fed governor Laurence Meyer, the head of a Washington policy research firm that bears his name.

"You are beyond full employment, you have confidence you are heading toward sustainable 2 percent inflation, and you have above trend growth for the next two years," he added. "And they are going slow."

While inflation does look calm — it has been at or above the FOMC's target only once since April 2012 — Tom Porcelli, the chief U.S. economist at RBC Capital Markets in New York, notes that wage pressures typically do not build up in an orderly fashion. In the last business cycle, one gauge of average hourly earnings jumped dramatically in a one-year period.

"You get this big run in earnings toward the end of the cycle. We are getting to that point," said Porcelli, who forecasts the FOMC will move to four hikes for 2018. "You can make the argument that the Fed is not buying enough insurance now against this outcome, and the real risk is the market is way off" when they do.

Source: bloomberg.com