Divergence of opinion in Fed circles regarding the outlook for inflation appears to be on the rise. While the June Minutes indicated that FOMC members are getting more comfortable with their forecast of a gradual increase in inflation over the medium term, Ms Yellen’s benign interpretation is far from universally shared.
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With tapering set to conclude by year-end, the debate on the timing of the first rate hike is heating up. St. Louis Fed president Bullard recently said that “we are going to overshoot”, predicting levels “well above” the Fed’s 2% objective by the end of next year as unemployment continues to decline. And while Mr Bullard describes himself as the “North Pole of inflation hawks”, if price pressures continue to gain traction, the consensus within the FOMC may acquire a progressively more hawkish tilt going forward. Dallas Fed president Fisher’s remarks last week make the point quite clearly: “…early next year, or potentially sooner depending on the pace of economic improvement, the FOMC may well begin to raise interest rates in gradual increments, finally beginning the process of policy normalization”.
Market action already suggests that anchoring the short end of the Treasury curve will be no easy task for the Fed, with forward rates rising and the yield curve on a flattening trend this year. As our chart illustrates, a flatter curve has historically been associated with a rising Fed Funds rate, although successive rounds of QE have caused this relationship to break down in the aftermath of the Financial Crisis.
At the same time, investor positioning is sending somewhat conflicting signals, as indicated by the simultaneous rise in short rates and the rather wide gap between futures-implied Fed Funds rate expectations and the FOMC’s latest median projections (the ‘dots’). We think this apparent inconsistency is driven by a combination of factors. On the one hand, this is partly due to the Fed itself. Ms Yellen’s rhetoric remains firmly on the dovish side, exerting a downward pull on market participants’ expectations across the curve. And weak economic activity in the first quarter may have unsettled some investors’ confidence in the sustainability of the US recovery, leading them to dial down their medium-term interest rate outlook. On the other hand, as the end of QE approaches and leading indicators point to a rebound in the second quarter, investors are also moving to price in some degree of normalization at the shorter end of the curve.
However, this apparent imbalance should resolve itself sooner rather than later. If we are right that US GDP growth will gather steam through the rest of 2014, and if inflationary pressures continue to build in tandem with a healing labour market, then we could easily see market expectations for the policy rate converge to, or even rise above the FOMC’s current ‘dots’ rather quickly. This would dwarf the debate on exit strategy technicalities, at least in the near term. It would also trigger a pick-up in volatility along with higher uncertainty about the path of US monetary policy. Just what the Fed seems to be calling for…or is it? Stay tuned.
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