Fed: Yellen’s framework points to four hikes - AmpGFX

Greg Gibbs, Director at Amplifying Global FX Capital, expects that a higher estimate of the neutral rate and a higher estimate of core inflation suggests that FOMC members, including Yellen herself, should be considering raising their projection for rate hikes this year from three to four and furthermore, the balance of risks around growth and inflation are likely to have tilted higher.

Key Quotes

“Yellen’s speech on 3 March did not aim to raise market expectations of more than three hikes this year.  Her aim was mainly to prepare the market for a hike this week.  Perhaps this reflected a desire to warn but not panic the market.”

“Most of her speech was an historical account of Fed’s rate policy decision-making.  It gave a sense that not much had changed since December, and a hike this week would be just one step in getting on with this process of policy tightening; at a faster pace than seen in recent years, but still gradual.”

“In her 3 March speech Yellen noted that the FOMC has revised down its estimate of the neutral long-run  real Fed Funds rate over recent years; “from 1-3/4 percent in June 2014 to 1-1/2 percent in December 2015 and then to 1 percent in December 2016.”

“The point of this discussion was to highlight that the Fed is still in a gradual tightening cycle and is likely to raise rates by less over this cycle than past ones.”

“If we were to use the December FOMC median projections for end-2017 (unemployment 4.5%, less the 4.8% neutral estimate, core PCE inflation 1.8%, less than 2.0% target), and assume the current neutral real policy rate remained at zero, three hikes would leave the effective real rate at (1.37% – 1.8% = -0.43%) still accommodative at 0.43% below neutral.”

“This might be justified since core inflation (1.8%) would still be below 2.0%; although at this stage the labor market might be a bit too tight relative to the Fed’s mandate.”

“However, consider what may have changed since the December policy meeting.  Firstly, the FOMC’s year-end inflation projection appears low.  Already the preferred core measure is at 1.7%, only 0.1% below the Fed’s year-end median projection.  Moreover, a number of alternative measures of underlying inflation are higher.  (Atlanta Fed’s PCE trimmed mean measures at 1.9% in January).  These suggest that the Fed’s choice of the most conservative measure of core inflation is likely to rise towards these alternative measures if the economy remains on its current path.  As such, it seems likely that there will be some upward revision in the FOMC’s year-end median inflation forecast.”

“Secondly, consider the FOMC projections of the neutral real rate.  It may be too soon to expect to see much upward revision in the long-run neutral real rate from 1% (although this certainly implies a pessimistic view of potential real growth).  However, it is likely that FOMC members begin to upgrade their current neutral rate from zero, or at least will project it to be above zero by year-end.”

“On 3 March, Yellen noted that the lower current neutral rate reflected “several additional headwinds to the U.S. economy in the aftermath of the financial crisis, such as subdued economic growth abroad and perhaps a lingering sense of caution on the part of households and businesses in the wake of the trauma of the Great Recession.”

“Fed member comments earlier in the week of Yellen’s speech highlighted that the global economic outlook had improved and consumer and business confidence in the USA had lifted to its best level in some years.  As such, those headwinds that were dampening the current neutral rate appear to have eased significantly since last year.  As such, it may already be the case that the neutral real rate is projected to be above zero.”