The Federal Reserve raised interest rates yesterday as the Treasury market reacted by lowering yields. The softer market yields could be a vote of confidence in the Fed’s monetary policy in the sense that inflation worries are contained. An alternative view is that the bond market is becoming anxious at the sight of tighter monetary policy amid falling estimates for first-quarter GDP growth in the US.
The Atlanta Fed’s GDPNow estimate for Q1 economic output slipped to 0.9% in yesterday’s revision (Mar. 15), well below the already sluggish 1.9% increase for last year’s Q4. CNBC’s survey of economists points to a modestly faster pace – the Mar. 15 Rapid Update estimate for Q1 is 1.5%, although that’s also below the gain in the previous quarter.
Economic forecasts can be fickle, of course, and so it’s premature to conclude that the macro trend is destined to slow in the kick-off to 2017. Keep in mind, too, that the New York Fed’s recent estimate for Q1 growth is dramatically stronger at 3.2%, albeit as of Mar. 10. It’ll be useful to see how tomorrow’s update compares.
Meantime, the Fed continues to squeeze monetary policy. In concert with raising the target Fed funds target rate 25 basis points to a range of 0.75% to 1.0%, the monetary base continued to contract in February. M0 money supply remained in the red for the 12th straight month, falling 5.9% from the year-earlier level in real (inflation-adjusted) terms.
Some economists think that even with the latest rate hike the Fed is still behind the curve.
“We have very low unemployment rate of 4.7%, we have inflation roughly at 2%, so rates should be normal now. And normal…would be at 3%. Instead, we are below 1 percent,” says Robert Heller, a former Fed governor.
The optimistic view is that inflation is stable and holding close to the Fed’s 2% target. In other words, mission accomplished. Although the headline measure of the consumer price index (CPI) accelerated last month to a 2.8% year-over-year increase – a five-year high – the core rate ticked down to a 2.2% annual pace, which is roughly in line with the trend over the past year. Using the more reliable core measure of inflation as a guide, the Fed appears to have succeeded in raising inflation without risking an upside breakout.
The one glitch at the moment, which could turn out to be a false alarm, is the weak Q1 GDP estimates. The worst-case scenario: the Fed continues to hike rates at the short end of the yield curve while the market trims longer rates due to worries about slowing growth. The result: the yield curve flattens and continues to move closer to the dreaded inversion, which historically has signaled elevated recession risk. We’re a long way from that tipping point, although the Treasury yield curve has become a touch flatter lately relative to recent history. The benchmark 10-year Treasury yield, for instance, fell to 2.51% yesterday from 2.60% the day before (via Treasury.gov) while the Fed funds rate ticked up.
The main counterpoint to gloomy forecasts at the moment is the strong growth in payrolls in the first two months of this year – a substantial improvement vs. the mild increases in last year’s third quarter.
The upbeat numbers for payrolls conflict with the weak estimates for GDP growth in Q1. But for the moment, it’s reasonable to give the hard data in recent history the edge over worrisome forecasts that may or may not be accurate. And let’s be clear: recession risk remains low, based on a broad reading of the data published to date.
But there’s a bit more uncertainty about the future — at a time when the Fed is tightening policy with plans to raise rates further. That’s hardly a reason to head for the hills, but it’s a risk factor that deserves careful monitoring.
According to the Fed’s revised economic projections, the Fed funds rate is on track to rise from the current 0.75%-to-1.0% range to 1.4% by the end of this year and 2.1% in 2018, based on the median forecasts. That’s not a problem if economic growth doesn’t deteriorate, which the Fed dismisses in its latest outlook data. Output is expected to hold at a modest 2.1% this year and next, the central bank predicts — unchanged from its December outlook.
Will reality challenge that view? The operative question for the next several weeks, as the final round of Q1 data is published: Is the macro trend turning wobbly as the central bank is becoming more confident about implementing tighter policy?