Fed's new interest rate policy creates uncertainty

Fed Chair Powell's press conference after the last FOMC meeting prompts me to rethink my view on Fed policy. In December, a majority of policy committee members believed the Fed would raise official interest rates three times this year. Until now, for reasons I explained last week, I thought the Fed would stick to that script and not raise interest rates any more. But Wednesday's press conference sheds a different light.

Here's, in summary, what Powell said (I'm paraphrasing, of course):

• The economy is growing strongly. In 2022, growth will exceed potential growth. The economy no longer needs support.
• The Fed has (more than) achieved its own policy objectives: inflation is above target and there is talk of 'maximizing employment'.
• Interest rate hikes will cause little or no damage to the labor market.
• Financial instability is only relevant for monetary policy to the extent that it affects economic growth. So preventing financial instability is not an end in itself.

When you add this up, Powell actually said that official interest rates are way too low and that the process of rate hikes will be very different from the process that started in late 2015 and continued into 2019. Then the Fed raised interest rates three times a year on average for three years. So things will clearly accelerate now because the circumstances are very different and the Fed has to bring interest rates to neutral much faster than then.

By how much will the Fed raise official interest rates this year? who knows??? So if the economy no longer needs support, interest rates should (at least) return to 'neutral', but where is that? For me, the capital market interest rate is a guideline in this regard. While the central bank is usually assumed to point the market in the right direction, it has more often been reversed. I note that although the US 1,8-year capital market rate has increased, it is still only XNUMX% (at the time of writing). I find that remarkable because:

• Inflation is way above that.
• Everyone knows that the Fed will soon end its asset purchase policy and will begin to shorten its balance sheet during the course of this year.
• And everyone now also knows that the Fed will raise official interest rates quickly and possibly sharply.

My interpretation is that the market thinks that the equilibrium interest rate is not very high and if the market is right it implies the risk that the Fed will tighten too aggressively and damage the economy. Economists then speak of a 'policy mistake'.

The real interest rate, measured by the effective yield on government bonds minus actual inflation, is extremely negative, as the following picture shows. What strikes me about that picture is that this real interest rate has not been above 2016% since the beginning of 1. That was not due to bond purchases by the Fed. After all, between the end of 2014 and the outbreak of the pandemic, the Fed did not pursue a buying policy and in 2018 and 2019 it even reduced its balance sheet total.

Will the Fed get inflation under control?
Ultimately, the Fed will definitely get inflation under control. Naturally! The only question is at what price. In the early 80s, the Fed, chaired by Paul Volcker, brought inflation under control at the cost of two rapid and painful recessions. I hope that a recession will not be necessary now, nor that the Fed will inadvertently cause a recession. But to be honest, you can't completely rule out such a 'policy mistake'.

Economists value the importance of expectations in the inflation process. The higher inflation expectations, the greater the chance of higher inflation. But how do you measure those expectations? There are various standards. The following image comes from the University of Michigan's monthly consumer survey. It is logical that the expectation for inflation has risen sharply in a twelve-month period. It follows the actual pattern of inflation quite closely. Expectations for the five-year horizon have also risen, standing at 3,1% in December. January figures will be published this afternoon (January 28). I would say that such inflation expectations are a cause for concern, but certainly not for very aggressive policies.

Inflation expectations can also be derived from the prices of some financial products. The following picture shows those expectations based on the so-called 5 year break-even rate. This is the percentage that makes the effective yield of conventional bonds with a maturity of five years equal to that of inflation-linked bonds of the same maturity. According to this measure, inflation will average 2,5 to 3,0% over the next five years. That is higher than in the past ten years, but certainly not excessively.

The following picture shows the expectations based on the so-called 5-year-5-year forward rate. This is an indication of the average expected inflation for a period of five years starting in five years, so say for the period 2027-2032. That expectation is currently about 2%. So the market clearly 'thinks' that higher inflation may last for a few years, but will be fully under control again in five years' time.

What does all this mean for financial markets?
Capital market interest rates have risen recently, but the absolute level is still modest, while there are plenty of reasons for the market to raise capital market interest rates. The fact that this does not happen implies that there are still various forces depressing capital market interest rates. I therefore do not expect a very significant further rise in capital market interest rates.

The situation is uncertain for equities. Equity markets rose sharply in 2021. Part of that price gain has since been given up. The two main risks for equity markets are a sharp rise in interest rates and a recession. Neither seems the most likely scenario to me. In the end, things can easily turn around if it turns out that the economy continues to grow, inflation falls and capital market interest rates rise only modestly. For now, however, uncertainty trumps and the tone will be set by: how fast and how much the Fed is raising official interest rates; by the perceptions about this; and by the changes in those perceptions.

German entrepreneurs more optimistic about the immediate future
The major Ifo index measuring German business confidence rose to 95,7 in January from 94,8 in December. It was the first increase after six months of decline. The improvement in business confidence was due to 'expectations'. The assessment of the 'current situation' became less positive. This was mainly due to the service sector. The entrepreneurs in the industry, on the other hand, take a more positive view of the current situation. It is clear that the infections caused by the omikron variant and the tightened lockdown measures are affecting the service sector. Given the easing being implemented in many countries, it seems that the positive expectations are justified.

The message of the Ifo index is similar to that of the Purchasing Managers Index (PMI) of IHS Markit. The composite PMI (services and industry) for Germany rose from 49,9 in December to 54,3 in January. The sub-index for the services sector rose remarkably strongly: from 48,7 to 52,2. Undoubtedly, this is a sign of optimism about the near future.

According to the IHS Markit survey, industry lead times are getting shorter while new order assessments were the most positive since September.

The data from IHS Markit also sheds interesting light on the evolution of costs and prices. In the services sector, input costs continued to rise across a broad front: energy, fuels, wages and materials. But in the industry price pressure actually eased somewhat. The input cost sub-index is still well above its historical average, but hit its lowest level in nine months. Undoubtedly, this is a first sign that inflation will moderate.

US economy grows solidly in the fourth quarter, but…
The US economy grew by no less than 6,9% in the fourth quarter compared to the third quarter (annualized, calculated in the 'European way', it amounts to a growth of 1,7%). Year-over-year growth was 5,5% in the fourth quarter and for 2021 as a whole, the US economy grew by 4,2%. Those are good growth figures in any case.

Nevertheless, there are some things to criticize about the figures for the fourth quarter. Of the 6,9% growth, 4,9 percentage points came from stock building. That is a lot and of course temporary. Perhaps we can put a positive spin on this after all. Stocks were not built up due to an unexpected drop in demand for goods. Both private consumption and corporate investment (excluding the construction of corporate buildings) grew steadily. The strong stock build-up then probably shows that companies are building up stocks of materials, etc. as a precaution. Apparently, the supply problems in those areas are less.

Due to the omikron variant, economic growth will undoubtedly decline in the first quarter of this year, but an acceleration of growth in the rest of the year is on the horizon.

In the past I have often referred to the strong growth of certain investments by companies. The following picture shows that after the outbreak of the pandemic, companies are increasing their investments in information processing equipment accelerated. In the fourth quarter, this expenditure was more than 26% higher in real terms than in the fourth quarter of 2019, just before the pandemic.

The last picture also points to a healthy development of business investment. The picture shows the shipment of capital goods. These are monthly figures and are stated in current prices. In December, the level was almost 19% higher than in December 2019. With such a strong growth in investment, you can expect that labor productivity will increase somewhat faster.

Outlook for economic growth is favourable
The prospects for economic growth are favourable. Now that the omikron variant appears to cause significantly less health damage than previous variants and it looks like lockdown measures will disappear further soon, the service sector will also be able to run normally. At the same time, it seems that supply problems in the industry are easing somewhat. There is still a long way to go in that regard.

The Fed will no doubt raise official rates in March and continue to do so throughout the year. There will almost certainly be more rate hikes than the three steps a majority of Fed executives were thinking about in December. This creates uncertainty for financial markets. That uncertainty will continue until it is clear how much inflation will fall. For now, however, that is not going to happen.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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