The Fed started its December meeting today, one in which they are highly likely to decide it’s time for another rate hike. Prediction markets are posting a 95 percent probability that the Fed lifts their benchmark interest rate tomorrow from a target range of 0.25-0.50 basis points (hundredths of a percent) to 0.50-0.75. I’m confident that prediction is correct.
So, whassup with that?
Why is the Fed likely to raise in this versus prior meetings? What’s changed? A lot, actually.
While the Fed is thankfully somewhat insulated from politics, they have to stay on top of interactions between politics, fiscal policy, markets, and growth. The so-called Trump rally—the DJIA is up almost 9 percent since Nov 8—is built on the notion that a business-friendly president whose cabinet is “stocked” with bankers and billionaires will oversee more upward redistribution of growth, along with financial market deregulation.
[The fact that such policies have, in the past, exacerbated inequality and inflated bubbles is clearly not…um…the focus of markets right now. Sometimes I think the fatal flaw of humans reduces to our unwillingness to give a crap about the future (inequality, recession, melting icecaps) when we can have something today. But I digress…]
Operationally, the Trump rally reflects his plan for a big, regressive tax cut (also infrastructure investment, though see below). Inflation and interest rates have firmed significantly since his election, based on the expectation that he’ll inject a serious slug of stimulus into an economy which is already nudging towards full employment.
Also, as the jobless rate has fallen, wage growth has accelerated, from around 2 to 2.5 percent, on average. The price of a barrel of oil is also up 15 percent (almost $8) over the past month.
All of this has bumped up inflationary expectations, if not core (sans oil, food) inflation itself. The figure below shows two series of market-derived inflation expectations, both of which turn up pretty sharply towards the end (before the election, but with a spike afterwards). There’s the “5-year, 5-year forward inflation expectation rate,” which captures expected inflation over a five-year period that begins five years from now. It’s just above 2 percent (the Fed’s target rate), meaning investors expect inflation to average a little over 2 percent between December of 2021 and December of 2026. The 10-year TIPS breakeven rate reflects similar expectations. (This rate is the difference between the yield on bonds that include an inflation risk premium and those on inflation protected bonds; once you “net out” the latter, what’s leftover is inflation expectations.)
The thing is, no one knows what president-elect Trump and the Congress will actually pull off. My guess is that these expectations are directionally correct but overblown. There will be a big tax cut, but perhaps not as big as the markets are pricing in. A serious infrastructure dive may also be a bigger question mark than many investors seem to think (Trump original idea is limited and not well constructed [sic])....MORE
But it doesn’t matter what I think. What matters is what the Fed makes of these expectations. More precisely, it’s the extent to which such movements signal a majority on the FOMC (the group that votes on the rate hike) that anchoring inflationary expectations requires a hike. Based on that standard, I can certainly see where they’d react to the recent upturns with another small rate hike.
But is a rate hike warranted?...