The Fed Is On Auto-Pilot - For Now

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by: AllianceBernstein (AB)

Originally published on September 27, 2018

By Eric Winograd

When it comes to the official US short-term interest rate, the Federal Reserve now appears to be on autopilot, with three more quarter-percentage-point increases likely by mid-2019. But after that, things should get more complicated.

To nobody's surprise, the Fed delivered its latest increase this week and telegraphed its plans to do likewise when its policy-making committee meets again in December. And it's entirely likely that it will follow the same script in March and June of 2019.

In other words, US monetary policy is likely to be a snooze over the next few quarters. But be sure your alarm clock is set to ring come June.

Trying To Get To Neutral

Why? It all comes down to the letter R. In economics parlance, R* is the symbol for the "neutral" rate of interest - the one that in theory keeps the economy in equilibrium if growth and inflation are near target.

With the US economy growing comfortably and inflation near 2%, the Fed believes it's appropriate to reach that neutral rate of interest. The committee's current estimate of R* is just short of 3%, or roughly 75 basis points higher than the current policy rate.

With Fed Chair Jerome Powell emphasizing that the current "gradual" pace of rate increases is the right one, it makes sense to expect additional 25 basis-point rate hikes in the next three quarters, which would bring the policy rate to the Fed's estimate of neutral.

Obviously, things could change. Growth could slow, for example, or inflation could accelerate, forcing the Fed to change course. But for now, policymakers appear likely to continue their march toward the neutral rate.

So far, so simple. The more interesting question - and the one with more significant longer-term implications - is what happens after the policy rate hits neutral? There are three camps emerging within the Fed, and how their arguments play out in the next few months will be interesting to watch.

1. Camp 1 sees no reason to push interest rates above neutral. With inflation close to target and inflation expectations well anchored, this group believes that a policy rate around 3% will be sufficient.

2. Camp 2 believes that the Fed may have to push rates beyond neutral. With the economy growing more rapidly than its long-term trend indicates, it should and the economy operating at full employment, this group thinks additional tightening will be needed to prevent economic overheating, financial market imbalances or both.

3. Camp 3 is perhaps the most interesting. Its members question whether it's possible to reliably estimate the neutral rate of interest. For instance, the neutral rate in the years before the financial crisis was sharply higher than what it may be today, when the economy is still recovering from the crisis. And as the economy continues to expand, R* could move higher again. If that's the case, additional rate hikes may be necessary just to get to neutral.

Expect More Rate Hikes In 2019

Our own view combines the views of camps 2 and 3. Because we expect inflation to be above target over the next few years, we think the Fed will probably have to push rates beyond neutral - even if the neutral rate itself is higher than currently estimated.

And we strongly believe that estimates of R* should be taken with a grain of salt. This is a variable that is hard to observe in real time. That is one of the many reasons why making monetary policy decisions is often more difficult than it appears.

We expect camps 2 and 3 to prevail over time and the Fed to raise rates four times next year (the market is pricing in two to three hikes in 2019).

Higher interest rates are going to be a challenge for asset markets, but the committee can ease the pain by minimizing volatility. That has been the case this year: rate hikes have not disrupted either the economy or markets. What's more, the Fed has been trying to increase transparency, and we're cautiously optimistic that rate hikes next year won't be disruptive either.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.