Fed Lifts Off, Future Hikes Pegged to Inflation - December 2015

CME Group

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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% M ar -2 00 9 Se p20 09 M ar -2 01 0 Se p20 10 M ar -2 01 1 Se p20 11 M ar -2 01 2 Se p20 12 M ar -2 01 3 Se p20 13 M ar -2 01 4 Se p20 14 M ar -2 01 5 Se p20 15 0% 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. 2 .