Goldilocks Enters the Breach

Benjamin M. Lavine, CFA, CAIA

Source: istockphoto

Assuming the Federal Reserve follows through on expectations of two more rate hikes this year (September and December meetings) and assuming core inflation holds at 2.1%, the U.S. is about to enter the ‘breach’ of positive real interest rates for the first time since the 2008 financial crisis.

We seemed to have entered a stage in the cycle where the U.S. economy is firing on all (or most) cylinders.   Employment has reached historically strong levels, and business sentiment remains positive as U.S. corporations bask in the afterglow of corporate tax cuts passed earlier this year.  All this despite ongoing trade disputes between the U.S. and its major trading partners.  Wage growth seems to be picking up but not enough to spark an acceleration in price inflation.  Consumer and business confidence are also at a cycle high.  Indeed, 10 years into the recovery, the U.S. economy has gotten its second wind with the Atlanta Fed forecasting 4.4% GDP growth for the third quarter as of 9/19/2018. 

Even with economic and political stresses plaguing Europe (Brexit negotiations impasse, Italy budgetary woes, migrant debates) and emerging markets (Brazil, South Africa, Turkey, India, and, of course, China), the economic growth outlook for the U.S. has never looked rosier, especially in light of a “low expectations” economy (incidentally, we believe the world will continue operating under a “new normal” setting of real growth unless the secular trends of aging demographics, high debt levels, and excess capacity are reversed).  And it is the secular “new normal” realities that should keep inflation in check over the longer run even if we see inflation expectations creep up higher from 2%.

Hence, the Federal Reserve finds itself in the (enviable?) position of raising the benchmark Federal Funds Rate two more times, which is priced into Fed Funds Futures (Figure 1).  This would take the benchmark rate to 2.25-2.50% by year-end.  Fed Funds Futures are only pricing in two rate hikes in 2019 whereas the Fed is expecting three rate hikes based on the latest dot plot forecasts.

Figure 1 – Fed Funds Futures Pricing in 2.25-2.50% Fed Funds by the End of the Year (As of 9/19/2018)

Source: Bloomberg

As we’ve written several times over the past year (see “Inflation: The Fed’s MacGuffin” and “The New Neutral”), the real Federal Funds Rate (RFFR), or the Fed Funds Rate less core inflation (Core PCE), had been negative for most of the post-2008 period up until last year when it caught up to the theoretical neutral real rate of interest (r*).  The theoretical neutral real rate of interest is forecasted by the Laubach/Williams model maintained by the San Francesco Federal Reserve, whose key input is the Fed’s estimate for sustainable real GDP growth (Figure 2).  As the reader can see from Figure 2, a 2.50% Fed Funds rate represents a 0.50% real rate assuming 2% core inflation.  0.50% may not seem much, but this will be the first time since 2008 where U.S. borrowers will need to contend with a positive real rate of interest as a baseline for setting future borrowing rates.  

Figure 2 – Real Federal Funds Rate Expected to Be Positive for the First Time Since the 2008 Financial Crisis and to Exceed the Fed’s Estimate of the Real Neutral Rate of Interest (r*)

As we’ve previously stated, the main risk to the U.S. financial picture is one of Fed overshoot, but this assumes that r* does not move off the zero bound and that inflation drops rather than continues to rise.  Core CPI has trended higher alongside increases in employment costs (Figure 3), which has, so far, provided the cover for the Fed to raise rates up to 2%.  But if core inflation holds around 2%, give or take, then future rate hikes will mean positive real interest rates. 

Figure 3 – Core Inflation Has Pushed Higher Alongside Employment Costs but Still Remains Around 2%

So, the onus has now shifted to r*, namely sustainable GDP growth.  If GDP growth rises without inducing greater inflationary pressures, then r* should rise giving the necessary cover for the Fed to raise rates without overshooting.  However, if the Fed overestimates r* and pushes real rates well above the neutral rate, then it risks overtightening.  In other words, the Fed believes the training wheels of quantitative easing and zero interest rates can finally come off but will closely monitor how well the U.S. economy can shoulder positive real interest rate burdens (much as a parent hovers right behind the child learning to ride a bicycle without the training wheels). 

President Trump may not like higher interest rates (higher rates to a real estate developer are like holy water to a vampire), but the Fed’s job is to maintain an interest rate level that can sustain the economy without inducing higher inflation or pushing the economy over the edge.  Time will tell if they’re successful at the latter. 

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of September 21, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing or visiting 3D’s website

By: Benjamin Lavine