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Overshooting expectations

| November 30, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

As 2018 winds down, expectations for the U.S. economy for 2019 have deteriorated. There is a general sense that the expansion is long in the tooth and vulnerable heading into next year. This pessimism has recently been priced into the market, which reflects lowered projections for the fed funds rate and rapidly dwindling inflation breakevens. The gloomy outlook seems unwarranted. Instead, look for the economy and monetary policy to surprise in the following ways: GDP growth will be closer to 3% than 2%, inflation will continue rising, and the FOMC will hike rates three times in 2019.

Not A Sugar High

The popular view is that the sharp acceleration in real GDP growth in 2018 was mostly a “sugar high,” brought on by fiscal stimulus.  This view is largely shared by the FOMC, as shown by the evolution of growth projections since the passage of tax reform nearly a year ago (see Exhibit 1).

Exhibit 1: Evolution of FOMC growth projections

Source: Federal Reserve

Fed officials have lifted their 2018 projections by a full percentage point, waning to half a percentage point for 2019, and even less in 2020.  Most telling of all, the longer-run estimates have not budged, even by a single tenth of a percentage point over that period.  Thus, policymakers see the fiscal stimulus coming from tax reform – and to a lesser extent, spending hikes – as fleeting.  Market participants appear to expect an even steeper slowing of growth next year.

While real GDP growth will most likely slow somewhat from the stellar 2018 performance, it will remain closer to 3% than to 2%.  Consumer spending should continue to expand at a steady pace close to 3%, as labor markets remain robust, kicking off accelerating wage and salary gains.  More importantly the boost to business investment will continue next year, because the key elements of corporate tax reform have transformed the economics of business investing in a way that is highly unlikely to have entirely played out over just a couple of quarters.

Probability: 75%.

Upside Risk to Inflation

Fed officials are generally content that inflation will continue to hold near their 2% target in 2019 after core inflation first hit that mark in March.  Market participants are even more sanguine, as TIPS break-evens have plunged in the past two months, presumably reflecting the swoon in oil prices in October and November.  The 2-year TIPS break-even rate has plunged from over 1.8% as recently as October 9th to a surprisingly low 1.22% at the end of November.  Even longer-term break-even rates softened dramatically, as the 5-year breakeven rate has dropped from 2.05% to 1.74%.  Market pricing appears to suggest that the Fed will be unable to maintain inflation at or above its 2% target, not only in the near term but for years to come.

In contrast, underlying inflation is likely to creep higher next year, reflecting relatively tight labor and product markets.  This dynamic was already responsible for the acceleration to target in 2018 for both headline and core inflation.  Another year of well-above-trend GDP growth should produce further tightening in labor and product markets, leading to continued upward pressure on prices.

A wild card for inflation in 2019 is the ongoing trade dispute with China.  Many U.S. companies are already using the imposition of tariffs as a reason to push higher prices on their customers, with mixed success but a better record than has been the case for much of the expansion.  Any further ratcheting up of tariffs next year is likely to have a noticeable impact on inflation, posing an upside risk to inflation, especially relative to market expectations.

Probability: 60%.

The Fed Stays the Course

Financial market participants have recently determined that Fed rate hikes are approaching an end.  Market pricing was already more dovish than the FOMC’s dot projections for 2019 and beyond, but the dip in equity prices and widening in a number of risk spreads along with the emergence of downside risks to global growth have led to a marked shift in policy expectations over the past few weeks.  At the time of the most recent FOMC meeting in early November, the January 2020 fed funds futures contract yielded about 2.95%, implying that the funds rate would end the year about 17 bp lower than the median FOMC dot projection of 3.125%.  Since then, the contract has rallied further, with another wave in the wake of Chairman Powell’s November 28th speech, taking the yield down to 2.69%.  This means that if the FOMC hikes in December, as expected, then the market pricing reflects less than 30 bp of tightening next year – barely more than one hike.

Based in large part on the economic view laid out above, the FOMC will need to continue raising rates significantly next year.  The median view on the Committee is that the neutral rate is about 3%, and most policymakers believe that, having overshot substantially already on the unemployment rate, the policy target will eventually have to move modestly beyond neutral, i.e. into the low-3%’s.  Look for the FOMC to continue to press forward until it gets to a roughly neutral level, which would imply two hikes in the first half of 2019 to bring the funds rate target to 2.75% to 3.00% by mid-year, and a pause at some point in the second half of the year.  In all, I look for three hikes next year (consistent with the median FOMC dot projection), or about 40 to 50 bp more than current market pricing.

Probability: 80%.

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