The Federal Reserve can take an optimistic view of the future

In the week ahead, all eyes will presumably be directed at the Fed statement due to be published in the wake of the upcoming meeting of the Federal Open Market Committee. However, there ought not to be all that much scope for surprises since a key-rate hike is not on the agenda this time round. Since the beginning of the year, the Fed’s main rate-setting body has been somewhat more optimistic about the economic situation than in 2017. This is undoubtedly a result of the US tax reform. The Fed’s projections for US economic growth were already raised to a noticeable extent in December, with a further upward revision coming through in March. The dose of fiscal stimulus and the planned deregulation measures ought to cause economic growth to accelerate over the coming quarters. In response to this, FOMC members will gradually ratchet up key rates between now and the end of the year. At present, the median key-rate projection of Fed officials – reflected in the “dot plot,” which captures the ongoing forecasts of the individual members of the Federal Open Market Committee – implies that the fed funds target range will be standing at 2.0% – 2.25% towards the end of the year. But the improved economic outlook is also being mirrored in the interest-rate expectations of FOMC members. At the meeting held last December, six members of the rate-setting committee still saw the fed funds rate below 2.25% towards the end of 2018 – only two did this March. Seven of the 15 board members are currently pencilling in at least three further tightening steps between now and December.

On financial markets, there is likewise uncertainty about how many tightening steps would add up to a “gradually more restrictive” monetary-policy stance – two, three or as many as four key-rate hikes over the remainder of the year? Without doubt, the Fed’s objective of calibrating interest rates in an optimum manner has not been made any easier by the tax reform. The new, more accommodative, stance on the tax front could lead to a pick-up in investment activity if companies ramp up their capital expenditure in reaction to tax incentives. Cyclical momentum could therefore remain on its current path. Numerous sentiment indicators are suggesting as much. What is more, both the PCE deflator and the core PCE rate are pointing to a moderate upward trend in inflation. Of late, the Fed has shown increasing confidence that the inflation rate is going to head up towards the bank’s 2% target. This confidence now indeed seems to be being borne out by the empirical data.

Against this background, the Federal Reserve is going to have to decide in the coming months how sharply the monetary reins can be tightened without conjuring up a recession. Economic history shows that monetary policy is the decisive variable when it comes to explaining US economic cycles. At the moment, fear of the US yield curve inverting is causing quite a few ripples. The US monetary authorities will therefore have to pull off a balancing act: to prevent the US economy from overheating in response to the tax reform while, at the same time, not jeopardising the current upswing. Up to now, the Fed’s measures have probably not had a restrictive impact on cyclical momentum. In the current environment, however, the Fed is pulling two levers at the same time which are shifting monetary policy in a more restrictive direction: key-rate hikes and balance-sheet reduction.

In view of the fact that the Fed is probably going to adhere to its policy of balance-sheet normalisation for the time being, key-rate hikes are the only possible monetary-policy lever which remains. A further hike in the fed funds rate is certainly not on the agenda for the coming week. And we are not expecting the Fed to tweak its forward guidance on monetary policy to any great extent. Nevertheless, there will probably be a lot of animated talk going on behind the scenes. For instance, FOMC members will probably discuss yield-curve flattening. Numerous monetary custodians have expressed concerns on this score, pointing to the possible danger of a recession. It can be assumed that the Fed would not basically be happy about the yield curve inverting. At the same time, Fed officials would probably not give their blessing either if capital-market yields were to continue to climb unchecked. Financing conditions in the United States have already tightened as a result of the latest run-up in yields, with mortgage rates and loan costs following Treasury yields on their upward path. Despite the tax relief which is coming through, these tighter financing conditions could well impose a burden on economic momentum in the coming quarters. In addition, the repercussions of the tax reform are, however, also likely to remain a talking-point among FOMC members. Last but not least, Fed officials will be bound to trade views on the possible implications of the current trade conflict.

All things considered, we are abiding by our existing forecast, which foresees a moderate rate-hike trajectory. In our opinion, there are numerous reasons why things should work out this way: yield-curve flattening, the sharp spike in capital-market yields, tightening financing conditions and the fact that interest rates are only rising comparatively moderately. Not least, it should be taken into account that the momentum of the economic recovery has been very low in this cycle compared with previous cycles. So far, there do not seem to have been any fundamental overshoots which the Fed would be compelled to lean against.

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