Contrary to the general market reaction following the United States Federal Reserve policy meeting last week, we still feel there’s a good chance that the Fed could raise rates as early as June.
The longer the Fed delays in raising rates, moreover, the greater the risk of asset price bubbles developing – which the Bank of International Settlements has recently suggested could be a greater economic risk than price deflation.
FED ACTIONS MORE HAWKISH THAN THE MARKETS THINK
Markets have been blindsided by a modest downgrade to the US economic growth outlook among Fed members, and a scaling back in their expectation for how fast the Federal funds rate will rise over the next year or so.
Against this, however, the Fed did remove the key word “patient” from its policy Statement, and suggested instead that an increase in rates “remains unlikely at the April FOMC meeting.” When previously quizzed about what the word “patient” implied, Chairperson Janet Yellen said it meant no rate rise was likely for at least the next two policy meetings. That suggests a June move is now a possibility.
What’s more, this interpretation is supported by Yellen’s press conference opening Statement, in which she noted “this change [removing the word patient] does not mean that an increase will necessarily occur in June, although we can’t rule that out.”’
Of course, June is still three months away, and the outlook for US rates is naturally data dependent. But if the US labour market continues to improve – as we expect – the Fed may find it very hard to justify not moving in June. Indeed, the consensus forecast among Fed members is that the unemployment rate will be between 5.0-5.2% per cent by year-end, which as Yellen noted would be “in line with participant estimates of the longer-run normal unemployment rate.”
US DEFLATION RISKS OVERBLOWN
We also question the view that the US is at risk of a deflationary economic slump. While annual growth in the headline consumer expenditure (PCE) deflator had dropped to a mere 0.2% by January, this largely reflects the sharp decline in energy prices over the past year – which is a net positive for the US economy. In other words, low inflation largely reflects a positive supply side shock – rather than being indicative of weak demand.
Indeed, annual growth in the core PCE deflator (i.e. excluding food and energy) was 1.3% as at January, which is only a little below its two-decade average of 1.7%
IS THE FED FIGHTING THE WRONG WAR?
We also note a recent paper from economists at the Bank for International Settlements* , which debunks the widely held view that deflation is necessarily a major problem. In a survey spanning 38 countries over 140 years, the authors find the link between output growth and deflation is “weak” apart from during the devastation of the Great Depression. By contrast, they find a stronger link between asset price deflation and weak economic growth – suggesting central banks should also consider the risks of keeping interest rates too low for too long and the associated risk of pushing up asset prices to dangerously high levels.
At 17.3 times forward-earnings, outright valuations for the US S&P 500 index are already becoming elevated though remain supported by persistently low interest rates.
*“The costs of deflations: a historical perspective” BIS Quarterly Review, March 2015