It will surprise no one if the US Federal Reserve increases rates at its December 16 meeting.
That fact appears to have been settled with the release of the October FOMC meeting minutes and a consistent series of comments and the accompanying theme from Fed speakers for the past month that the time is right for the first rate hike in the US in nine years.
But while the timing of the first move seems settled, there remains some debate about how far or how fast the Fed will be raising rates. Of course, Fed speakers recently have been at pains to signal that the moves will be data dependent.
Inevitably that means with many and varied views about the path of the US economy in the year and years ahead, the magnitude of the Fed’s tightening cycle, or at least its speed, is still subject to some debate.
But that debate, and the uncertainty around it, makes a note released over the weekend by Goldman Sachs’ US chief economist Jan Hatzius and his team an important contribution to market thinking.
Hatzius and his colleagues characterise the US as undergoing a “Tortoise Recovery” but say that they “expect the committee to raise the funds rate by 100bp next year, or one hike per quarter”.
On the face of it, that seems a reasonable rate of tightening given where the employment market is in the US, the emerging wages cost pressures and the lower potential growth rate. But Hatzius highlights the Goldman Sachs call of 100 points of tightening is “a fair amount above the 55-60bp pace priced into the bond market”.
That’s a risk for markets if they get a little spooked that the Fed is going to move faster than currently priced.
But Hatzius is quick to highlight he sees the risks to his forecasts as being to the downside. He also makes a compelling case for why the Fed has to move in the next two meetings, December or January, and why rates will continue to rise after that in a steady fashion.
First, he asks the question why the Fed will be hiking when there is “only moderate growth in the economy as a whole, stagnation in the industrial sector, and an uncertain global environment?”
The reason, he said:
Is that although the funds rate has been stuck at zero for seven years, a lot has happened “under the surface”. Exhibit 9 shows the federal funds rate and the policy prescriptions from a range of Taylor Rules. For several years after the recession, most standard policy rules said the FOMC should cut rates well below zero, if that were possible. Now, because of the cumulative progress the economy has made since 2009, even relatively cautious versions of the Taylor Rule call for raising the funds rate sometime soon. The rule that we think best describes Fed Chair Yellen’s views—which uses the U6 unemployment gap and a zero equilibrium funds rate—says the FOMC should hike at the December or January meeting, if taken literally. Thus, the same basic framework that has kept the Fed at zero—and that has guided our relatively dovish policy views—now suggests the process of normalization should begin.
Here’s the chart:
So, the need for a rate hike is settled. But the vexed question for the market, the one that really matters in the year ahead, is the pace of Fed rate hikes.
Hatzius acknowledged that the Fed has, in various degrees has characterised the tightening cycle as “‘gradual’, ‘shallow’, ‘slow’, ‘halting’ and even ‘crawling’.”
Again he refers to Fed modelling, or specifically a model built by San Francisco Fed president John Williams and Federal Reserve Board Monetary Affairs director Thomas Laubach.
It’s all a question of the “equilibrium funds rate” Hatzius says. The catch is, it’s not an observable benchmark and so it’s open to conjecture. But Hatzius gives traders a guide to what the Fed might do.
In practice we suspect the pace of rate hikes will be guided by three factors: (1) the extent to which inflation appears to be returning to target, (2) how financial conditions respond to the first few rate hikes, and (3) whether growth remains above trend.
Hatzius’s call that the Fed will increase rates at a 25 basis points per quarter rate still feels gradual. But given the Fed only meets every six weeks, it still implies a rate hike every other meeting.
Hatzius and Goldman have clearly placed their bets.
But, in a nod to the acute uncertainty that has pervaded markets in 2015, Hatzius adds the jury is still out and if “financial conditions tighten more than expected, if growth slows, or if inflation fails to rebound as expected, then the FOMC might delay further rate increases”.
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