Independent Thinking®
Evercore ISI on the Outlook for U.S. Interest Rates
July 30, 2018
Editor’s note: Krishna Guha is Vice-Chairman of Evercore ISI and heads the Global Policy and Central Bank Strategy team based in Washington, DC.
Evercore ISI’s Washington office is ranked on the Institutional Investor’s All-Star Team for Washington research, which is based on a survey of money managers. Evercore ISI is one of the sources of research considered by Evercore Wealth Management.
At the Humprehy-Hawkins testimony in July, Federal Reserve Chairman Powell set out a phased two-stage approach to monetary policy. The Federal Open Market Committee, or FOMC, would continue steadily raising interest rates at the current gradual pace – de facto once a quarter – “for now.” Then, in a less sharply defined second phase, the Fed would feel its way back to a neutral rate setting before considering whether it might need to go beyond this into outright restrictive territory to curb overheating.
This approach reflects the challenges facing the Fed as it attempts to preserve current favorable economic conditions – low unemployment and inflation around target – in the face of a big shock from fiscal policy and a second potentially large shock from trade conflict.
Added together, the recent Trump tax cuts and sequester-busting Congressional spending deal make up the biggest fiscal stimulus the U.S. economy has experienced at this stage of the business cycle in many decades. This stimulus ought to add around 70 basis points to growth in both 2018 and 2019, although this effect could be dampened some by trade-related uncertainty.
The last comparable episode was back in the 1960s with “guns and butter” (the Vietnam War and the Great Society) under the Johnson administration, ultimately leading to excess inflation, recession and the beginnings of a prolonged period of poor economic performance. A huge amount has changed in terms of the nature of the economy and labor force since then, but Fed officials are very aware that the 1960s experiment did not end well and want to avoid overheating this time.
The likelihood that inflation will run away on the Fed in the next year or so seems low. While unemployment is at around 4% this summer and expected to decline further, labor participation has firmed, bringing additional workers into the labor force. At the same time, wages are rising only gradually, the modern inflation process is moving slowly, trend inflation is around target, and inflation expectations appear muted.
But the FOMC has to worry about overheating on a three- to four-year view, with this trend to growth and rapid hiring pushing unemployment to levels (perhaps in the low three percent range) at which excess inflationary pressures slowly begin to build or even accelerate. If the Fed wants to sustain the expansion, it has to prevent this from happening.
Trade conflict further complicates the Fed’s task. Trade uncertainty is already likely dampening the investment outlook to some degree. A descent into a full-blown trade war would push prices higher and growth lower – a difficult combination for the Fed. In particular, the growth impact of a full-blown trade war is hard to model and may well be greater than conventionally estimated. This is because traditional models likely shortchange the impact on financial markets and confidence, as well as the costs of disrupting globally integrated supply chains.
We believe that in the event of a full-blown trade war, the Fed would try to look through the initial first round effects of tariffs on prices and support growth, provided that inflation expectations remained unchanged and there were few signs of the initial tariff-driven price increases infecting the larger inflation dynamic. However, this is not a simple exercise.
For the time being, the strength of the economy under fiscal stimulus and the need to balance trade risks against overheating risks mean that the Fed has a strong default to continue with some further quarterly rate hikes, absent a sharp deterioration in the outlook (perhaps caused by trade escalation), and then move back toward a neutral rate setting.
Fed officials tend to see neutral rates at somewhere between 2.5% and 3%. As the Fed approaches the lower end of that range, it will move out of the current phase of steady quarterly hikes and into a more empirical meeting-by-meeting assessment of how much further it needs to go to prevent (or if needed, curtail) overheating.
That assessment will be informed by a wide range of market and macro data. The classic yield curve slope – which gets outsized attention in markets but the Fed leadership thinks is distorted by quantitative easing effects – will be only one part of the evaluation. In the end, neutral is as neutral does – and while the Fed might pause to look around in March or June 2019, it will only stop when it is confident that under the prevailing rate setting unemployment and inflation will stabilize at levels that are sustainable and consistent with its goals.
Provided that trade conflict does not become a full-blown prolonged trade war, we continue to suspect that rates will head to 3%-3.5% before the tightening cycle is over, with essentially all this remaining tightening taking place over the next 18 months. Even if we avoid the most extreme trade outcomes, the difficulty the Fed will face threading the needle in the period ahead – tightening just enough to prevent overheating under fiscal without overdoing it as fiscal cools off with all the complications of trade conflict – should not be underestimated. As a result, our view is higher than normal that there is a risk of recession on the 2020-2021 horizon.
For information on Evercore ISI Research, please contact Evercore Wealth Management Partner and Portfolio Manager Charlie Ryan at [email protected].