Thursday, March 31, 2011
This chart shows the market's expectation of where the Fed funds rate will be in one year's time. The one-year forward funds rate is expected to be 50 bps, which equates to approximately one very modest "tightening" of monetary policy (the funds rate target is currently 25 bps). Thus, no matter what you may hear people saying about what the Fed is expected to do over the next year, the current market consensus is one tiny move up in short-term interest rates sometime around February or March of next year.
Now, for things to actually turn out that way, I would argue that the economy is going to have to prove very sluggish, growing at no more than a 3.5% rate, and inflation is going to have to stop rising. Last year the economy grew 2.8%, and few forecasters are predicting a significant pickup (I think we could see 4%). Meanwhile, on a 3-mo. annualized basis, all measures of inflation have turned up meaningfully: the CPI is 5.6%, up from a low of -13.1%; the core CPI is 1.8%, up from a low of -0.2%; the PCE deflator is 4.0%, up from a low of -8.6%; and the core PCE deflator (the Fed's preferred measure) is 1.4%, up from a low of 0.2%.
Fed governors are not exactly unanimous in their opinion of the need to continue with QE2. Some argue that QE2 should be suspended next month, while others feel comfortable running QE2 through June as previously announced. What happens will be largely driven by the numbers. If inflation continues to pick up, the hawks are going to become more numerous and vocal, even if the economy doesn't pick up. Given the weakness of the dollar (at or near all-time lows in both nominal and real terms against a broad basket of currencies) and the strength of commodities (with most trading at all-time highs and up sharply in the past two years), I will be very surprised if inflation does not continue to heat up.
Finally, even if the Fed does raise rates sooner than is currently expected (something I expect), I doubt that this will be bad news for the equity markets. It would almost certainly be disruptive for the Treasury market, since rates out to 10 years are largely driven by the expected future path of the Fed funds rate. And it could cause corporate bond investors to get a case of the willies, though not a serious one, because spreads are still wide and it would take a whole lot of tightening to threaten the economy. It would be very positive for the dollar, whose weakness reflects a debilitating loss of confidence on the part of investors worldwide, because a Fed tightening even in the face of a modestly growing economy would show that once again the Fed has its priorities correct. Without a strong dollar, economic growth potential can quickly be frittered away on speculation, inflation, and asset market bubbles.
In short, an early tightening move would on balance be very good news in my opinion, and a welcome event indeed.
Posted by Scott Grannis at 7:04 AM