1) BLU PUTNAM, CHIEF ECONOMIST AND MANAGING DIRECTOR
CME GROUP
16 DECEMBER 2015
Fed To Adopt a Very
Cautious, Inflation-Based
and Data-Driven Approach
to Future Rate Hikes
All examples in this report are hypothetical interpretations of situations and are used for explanation
purposes only. The views in this report reflect solely those of the author and not necessarily those
of CME Group or its affiliated institutions. This report and the information herein should not be
considered investment advice or the results of actual market experience.
The Fed prefers to monitor the inflation rate as measured
by personal consumption expenditures. This is not the
headline consumer price index, but they do track each
other. The Yellen-Fed also seems to be placing more or
less equal weight on the general inflation trend, which
includes food and energy, as well as core inflation, sans
the two volatile components. Currently, general inflation
Figure 1:
US Core Inflation and Federal Funds Rate
Year-over-Year Inflation // Percent Interest Rate
Inflation Likely to Remain Subdued and Not Rise
Above 2% in 2016
is hovering just above zero while the core rate is between
1% and 2% (Figure 1). We expect the general rate of
inflation to rise toward the core rate during the spring
and summer of 2016. Since the big drop in wholesale
energy prices was in Q4/2014 and retail refined product
prices fell in Q1/2015, the comparison with these sharply
lower prices will drop out of the year-over-year calculations
as we progress toward the summer of 2016.
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The Federal Reserve (Fed), guided by Chair Janet Yellen,
is likely to follow a very different path and much less
aggressive approach for future rate hikes than the Fed
under Alan Greenspan. During the last two tightening
episodes under Greenspan, the Fed quickly raised the
target federal funds rate to above 5% even though core
inflation was around 2%. The Yellen-led Fed will probably
be much more cautious. There is no end-point target rate,
even if members of the Federal Open Market Committee
(FOMC) have views about the long-run possibilities. It is
not even clear if the Fed wants to take the effective federal
funds rate above the core rate of inflation. What is clear
is that only after inflation data shows incremental
increases will this Fed even consider additional
rate hikes. Thus, all attempts at establishing historical
parallels, in terms of the impact of rate-hike cycles on the
economy, should be taken with a grain of salt. This Fed is
truly being much more cautious than we have seen before.
Source: Federal Reserve Bank of St. Louis FRED Database (PCEPILFE, FEDFUNDS)
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2) 16 DECEMBER 2015
Sharply higher rates, say back to 5%, certainly would be a
negative for the economy but that is not in the cards.
Figure 2:
US Treasury 10-Year Yield & Core Inflation:
From September 2008 - present
4%
Fed Maturity Extension and QE
Programs
3%
10-Year Treasury
2%
We are now in an era of low inflation that is likely to last
until there is a credit boom – either due to a shift toward
an aggressively expansionary fiscal policy or a desire by
businesses and consumers to spend more and save less,
leading to more lending. Neither scenario is likely over
the next several years. Subdued inflation suggests a
slightly flatter yield curve (Figure 2).
1%
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Source: Bloomberg Professional (USGG10YR & PCE CORE)
More fundamentally, longer-term prospects for both
general and core inflation are quite subdued. The
tremendous competition in global trade is keeping a lid on
inflation. Retiring baby boomers are spending less per
capita than they did in their peak earning years and are
starting to save more (about time). Banks are constrained
by capital ratio regulations and their own risk management
processes, and so are highly unlikely to go on a lending
binge and expand consumer credit aggressively. Inflation in
the 1.5%-to-2% range is likely for end-2016.
Essentially, the Fed is now quite powerless to push
inflation higher without the complicity of a very
expansionary fiscal policy. Through Quantitative Easing
(QE), the Fed can buy all the outstanding government
debt it wants and yet the impact on total spending will
be next to nothing if the U.S. Government chooses not
to increase its spending (i.e., adopt an expansionary
fiscal policy). Zero rates matter very little, too. Pushing
the federal funds rate to 0% and getting the 10-year
Treasury below 2% with QE did not impact government,
business, or consumer spending in any material way. The
U.S. economy’s natural growth rate is probably between
2% and 2.5% and that is what we have been getting very
consistently since 2010.
By the same token, small rises in rates and no QE will not
matter either. The difference for business and consumer
borrowing (and spending) when interest rates range from
0% to 1%, or 2% is next to nothing. Amid heightened
financial regulation and sophisticated interest rate
risk management, the U.S. economy is actually quite
insensitive to rate changes, at least in the 1% to 2% range.
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