Markets Are Underestimating the Fed

(Bloomberg) -- The Federal Reserve will release its latest statement on monetary policy today, and although no change is anticipated, it’s becoming clearer that interest rates are too low and the risk of an acceleration in the pace of rate increases is much higher than currently perceived by investors.

The Fed’s doves have successfully advocated for a very slow pace of rate increases because inflation remained below the Fed’s 2 percent target despite the labor market being at full employment. After all, if the labor market were really operating beyond capacity, inflation would be increasing. So the doves could defend their stance by suggesting that inflation wasn’t a problem, unemployment might decline further, and the Fed should not prevent more people from being hired with inflation still below target.

This thesis breaks down now that inflation has reached the Fed’s target more than a year ahead of the central bank’s own public projections. The consumer price index rose 2.4 percent over the past year and the core CPI, which excludes food and energy, gained 2.1 percent. Since July, however, the pace of CPI increases has picked up, to 2.9 percent. So, the tight labor market may finally be coming home to roost in the form of faster inflation.

Fed officials who had until recently argued that the central bank should maintain a slow pace of rate increases, or even no increases at all, have reversed their positions and now support the gradual normalization approach taken by the Federal Open Market Committee. For example, Federal Reserve Bank of Minneapolis President Neel Kashkari, who voted against rate increases while a member of the FOMC, has come out publicly supporting the current gradual rate path. Fed Governor Lael Brainard has also retreated from her dovish views.

But the game may be changing faster than the views of the Fed’s members. The recent acceleration in inflation now poses significant risks to the current slow normalization approach. While companies have been reporting labor scarcity for a few years and an inability to fill vacant jobs, they didn’t follow through by raising starting wages to attract workers — until now.

Companies are experiencing a rise in turnover rates as workers accept better paying jobs elsewhere. A growing list of employers is finally boosting wages to keep workers, including McDonalds and Target. The Employment Cost Index, which attempts to adjust for changes in the mix of jobs, shows that labor costs are now also accelerating. After rising at a roughly 2 percent pace for some years, it has increased by 2.7 percent over the past four quarters, and at a 3.2 percent annual rate in the first quarter.

With unemployment quite low at 4.1 percent and fiscal stimulus from the recent tax reform working its way through the economy, there is a compelling case for monetary policy to be neutral, or even slightly restrictive, rather than stimulative, as it is now. If inflation continues on its trajectory, it could hit 2.5 percent or more before the end of the year, meaningfully higher than the Fed’s 2.1 percent public projection. If the Fed continued on its path of hiking rates three times in 2018, the federal funds target rate would be 2 percent to 2.25 percent at the end of the year, quite likely below the 12-month inflation rate. Policy would still be stimulative at that point and investors would be right to ask if the Fed is behind the curve.

Fed officials no doubt understand these arguments and they are drifting in the direction of four rate increases this year instead of the three they had been projecting. But even if they implement four hikes this year and four more next year, more than is currently projected, the funds rate would only be in the range of 3.25 percent to 3.50 percent, while unemployment would likely be 3.5 percent or lower. These conditions suggest inflation would be under considerable upward pressure. Expect the Fed to step up the pace of rate hikes before long. 

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