Yellen takes the reins

Since the Federal Reserve’s move to taper quantitative easing in 2013 (and subsequent market turbulence known as the taper tantrum), we’ve seen a consistent theme in monetary policy: The Fed has generally overestimated growth and inflation, and as a consequence, its projections on policy rates. In fact, the market has consistently done a better job of forecasting inflation and policy than the Fed, creating a persistent gap in expectations.

My colleagues and I have reflected on this trend since the early days of CIO Weekly Perspectives. But importantly, what we’ve seen over the past six months, punctuated by the Fed’s 25-basis-point move in December, is a convergence of forecasts from the bond market and the Fed. To wit, the FOMC now anticipates three rate hikes in 2017, while the market expects somewhere between two and three, depending on the date of measurement.

To see why, it helps to understand that the Fed’s forecasting and modelling were confounded for some time by certain themes that we’ve written about. That is, persistently weak productivity and unusual patterns in the labour market — specifically the rapid decline of the workforce participation rate despite an improving economy. The combination dampened growth and inflation in ways the Fed did not anticipate. Multiple global economic strains made matters worse, including the deceleration in emerging markets, the commodity price collapse and sluggishness and uncertainty in Europe. All triggered caution lights that kept monetary tightening from gaining steam.

The field Has opened up

However, we’re in a different environment now. Pushing aside the current political turbulence, economic activity is gaining momentum, consumers are more confident and equity markets are up, while inflation is showing moderate acceleration. Encouragingly, the labour force stagnation that hampered the Fed so much is showing signs of dissipating, although productivity remains a long-term challenge.

The net effect is an inflection point for monetary policy, both in terms of perception and substance.

Over the past few years, the Fed has largely been a market follower, and very careful as to the information it conveyed to investors. The notion was to avoid doing harm to the markets or to a fragile economy. But a “stay out of the way and don’t make trouble” approach can only take you so far. And we warned repeatedly that the Fed would at some point need to be more assertive in its communications and actions — lest events become even more difficult to influence.

Will the Fed actually lead?

As I write today, the Fed has an opportunity to move into a position of leadership vis-a-vis the markets for the first time since the end of quantitative easing. Fortunately, that appears to be happening, as reflected in the upward shift of policy expectations in December, Yellen’s more hawkish recent speeches and the “sooner is better than later” minutes from the FOMC’s January meeting. We’re not talking about anything dramatic, but there appears to be a trend.

Looking ahead, the Fed has seven more meetings this year in which to make good on its expectation of three additional rate increases. At this point, the market is discounting just a 22% chance of an upward move in March, and debating whether May or June is a more realistic time frame. Without opining about a specific meeting, we think the Fed could be a bit more aggressive than advertised — with at least three but possibly four rate increases on tap this year.

How will the market take it? Pretty well, we think. The gains in risky assets, this year’s retreat in the dollar (after a nice run in 2016) and the persistent rise of inflation since mid-2016 reflect a market with some resilience — affording the Fed a level of freedom it hasn’t had for some time.

Naysayers argue that the Fed’s preferred inflation measure (the Personal Consumption Expenditure index, or PCE) is still 40 basis points below its target. But, in our view, they are missing the point. Given where we are in the business cycle and against the backdrop of increasing inflation, short-term rates are still artificially low, something the Fed is acutely aware of but tends not to emphasise.

Brad Tank, Chief Investment Officer — Fixed Income, Neuberger Berman