At a Glance
- There are two competing scenarios for the Fed in 2019
The Federal Reserve (Fed) has hit its targets for the dual mandates to foster employment growth and price stability.
The unemployment rate is hovering just below 4%, and monthly jobs gains have averaged over 200,000 in 2018. On the inflation front, the 2% target has been achieved.
As measured by the consumer price index (excluding food and energy), core inflation is 2.3% (through July), and the core personal consumption expenditure price index is just below 2% at 1.90% (through June). Hence, the Fed is now providing guidance that it seeks a “neutral” interest rate policy, rather than an accommodative one.
My analysis suggests there are two competing scenarios for the Fed in 2019. Both scenarios assume the Fed provides two more rate rises in 2018: 25 bps in September and again in December, which means the federal funds target range would be 2.25% to 2.50% as 2019 commences.
Push to 3%-plus?
The case for pushing rates higher and higher is that all-in consumer price inflation is now at 2.9%, and possibly headed toward 3.5% or 4%, driven by the robust health of the labor markets.
This scenario argues that the Fed is in danger of falling behind the inflation curve, and a “neutral” interest rate policy would require the fed funds rate to be at least equal and preferably slightly above the prevailing rate of inflation.
We note that on Friday, August 10, 2018, the federal funds futures maturity curve put the market consensus target rate range at 2.50% to 2.75% by end-2019, which suggests just three rate rises between now and the end of 2019. My analysis puts the probability of the Fed pushing rates to 3% or above, meaning four or more rate rises before end-2019 at about 30%.
Go on Hold in 2019?
The argument that the Fed might raise rates twice more and then go on hold rests on several assumptions.
First, the Fed appears very aware of the rise in both public and private debt loads to record levels. Rising rates increase the cost of servicing debt and raise the risks of recession.
Second, and related, the yield curve has flattened considerably over the past twelve months. By my analysis the yield curve already indicates that the Fed has achieved a “neutral” interest rate policy, meaning that more tightening which might completely flatten or even invert the yield curve could be the trigger for a 2020 recession.
Third, so far, the US-driven trade war is not impacting the US economy very much (See Erik Norland’s research report on this topic), but global growth does appear to be slowing and many emerging market countries are feeling the pressure. A global slowdown would decelerate US growth, even if it did not cause a recession.
My analysis disagrees with the futures market consensus, as it puts a 60% probability on just two more rate rises before the Fed goes on hold. By the arithmetic of probabilities, the middle ground of three rate hikes before the end of 2019 has only a 10% probability, as I think the Fed either goes dovish in 2019 or flips to worrying about inflation pressure, with little middle ground.
Looking to 2020, Recession risk at 33% and rising.
The current US economic expansion will soon be the longest on record. I do not think economic expansions end because of old age – it takes a domestic policy mistake or a serious external disruption. As indicated above, with rapidly rising debt loads, a nearly flat yield curve, escalating trade wars, and disruptions in emerging market currencies and economies, there is no shortage of factors which might serve as a catalyst for ending the current expansion. The probability of a recession in 2020 appears to have risen to one-third. This means that there is also a 33% probability of a rate cut by the Fed in 2020, should a recession actually occur.
I also note that when the Fed cuts rates, it does not necessarily do so in 25 bps increments or even at a regularly scheduled FOMC meeting. No, since former Fed Chair Alan Greenspan’s aggressive tightening in 1994 was widely viewed as a mistake, rates go up in well-defined 25 bps increments. On the way down, though, rates can be cut quickly and sharply once recession-like data starts showing up in the employment situation report or we see credit market spreads widening dramatically and indicating severe financial pain