Fed rate unlikely to move much above 2% next year

The Fed is expected to raise rates again this week. But it continues to wrestle with low core inflation, while the impact of tax cuts will need to be monitored.

After the quarter-point rate rise expected on 13 December, the Federal Reserve will have pushed through the three rate hikes it signalled earlier in the year. For once, it has not under-delivered. Meanwhile, the gradual, ‘passive’ decline in the Fed’s balance sheet has been mostly ignored by markets.

Broader financial conditions have eased this year despite the Fed’s monetary tightening. Corporate bond spreads, for instance, have remained very tight and bond issuance has flourished. It is precisely because broader financial conditions are seen as too accommodative by many Fed officials that the Fed is ready to ignore the persistent under-shoot in core inflation and to continue hiking rates, in our view.

With near-term Fed tightening will be mostly driven by rising anxiety about over-accommodative financial conditions, we think the Fed is focused on reaching a nominal rate of about 2% in the coming quarters. The risks to our view are tilted slightly to the upside due to the potential confidence-boosting effect of tax cuts. Even though the prospect of tax cuts means the Fed could adopt a more hawkish style of communication, we do not believe they are a game changer when it comes to the Fed’s plans for normalisation. Given our forecast for core PCE inflation to remain below 2%, we expect the interest rate on excess reserves (IOER) to plateau at 2.0% in June 2018.

We do not think the ‘changing of the guard’ at the Fed board, including the appointment of Jerome Powell as Fed Chair, will impact the Fed’s reaction function in the coming quarters. Powell, a long-time Fed insider, has insisted on continuity with his predecessors, Janet Yellen and Ben Bernanke. There remains some residual uncertainty about the other vacant seats, however.

Powell has indicated that the Fed should continue shrinking its balance sheet for another three or four years, and we think it is highly unlikely that the Fed will revisit its plans unless there is a significant slowdown in the economy.

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