Fed’s motivation crucial to determine rates’ path

04. December 2018, 17:39 Uhr

Ever since Jay Powell’s remarks last week that he believes interest rates are almost at their neutral level, the debate is on how often and how quickly the Fed will continue to raise rates during 2019.

The argument frequently deployed in doubt of the Fed’s ongoing monetary tightening is an alleged slowdown of the US economy, heralded by spluttering housing among other indicators and due to Donald Trump’s fiscal stimulus wearing off over the course of the new year. The debate then mostly continues to centre on whether that slowdown really is at hand, and if so, what magnitude it might take. Eventually, most observers arrive at the conclusion that US central bankers will reduce the speed of monetary tightening, if only to prevent erring on the wrong side of the curve. What is almost always overlooked, though, is a somewhat counterintuitive motivation of the Fed: To continue raising rates precisely to get ahead of the business cycle so as to have sufficient fire power to fight a recession thereafter.

It reads a bit like creating the crisis in the first place one intends to battle; yet the fact remains that even at around three per cent, nominal US rates still are way off their level in previous late stages of the business cycle when the Fed usually went on to slash rates by some 500 basis points to stave off a recession. Now, readers might object what is relevant are real instead of nominal interest rates becoming negative, which is perfectly true, of course. But with inflation at around four per cent at the end of past business cycles, it was sufficient for the Fed to lower its policy rate to some three per cent in order for real rates to turn negative, whereas in today’s environment, nominal rates would have to fall back to virtually zero again to yield the same level of negative real rates.

In other words: The Fed would quickly run out of traditional monetary policy and would have to reintroduce unpopular QE. It is safe to say that Jay Powell and most of his colleagues (with the likely exception of the dovish Neel Kashkari) prefer not to be forced to do so, but rather to have sufficient room for falling rates at their disposal.

Barring an all-out crash on equity and/or bond markets, we therefore project the Fed to continue raising rates well into 2019 and at least two times at that, betting on labour supply to become yet more squeezed as well as productivity to keep up sufficiently to reach a neutral level of real interest rates between 1-2 per cent. Thus, rates could climb to at least three per cent if balanced by inflation in excess of two per cent – which is what we expect.