- Bloomberg – Fed’s Brainard Says Gradual Rate Hikes Remain ‘Appropriate Path’
Europe and emerging markets present downside risks to outlookBrainard’s speech validates investor expectations that the central bank will raise the benchmark lending rate when officials next meet June 12-13, and her outlook appears similar to the policy path published by the Federal Open Market Committee in March. At that time, central bankers forecast the federal funds rate that keeps supply and demand in balance in the economy over the longer run at 2.9 percent. They forecast the rate would be 3.4 percent at the end of 2020. “It seems likely that the neutral rate could rise in the medium term above its longer-run value,” said Brainard, who was appointed by President Barack Obama to the central bank’s Board of Governors. “I expect current tailwinds to boost the neutral rate gradually over the medium term but leave little imprint on the long-run neutral rate.”
- Federal Reserve – (Lael Brainard) Sustaining Full Employment and Inflation around Target
In the latest report, real gross domestic product (GDP) increased 2.2 percent at an annual rate in the first quarter of 2018, a slowdown from the 3 percent pace in the final three quarters of 2017. The first-quarter slowdown was especially noticeable in consumer spending, which increased at only a 1 percent pace last quarter, compared with 2-3/4 percent in 2017. By contrast, business fixed investment increased 9 percent at an annual rate last quarter, surpassing its robust 2017 pace. I expect real GDP growth to pick up in the next few quarters. In particular, the fundamentals for consumer spending are favorable: Income gains have been strong, consumer confidence remains solid, and employment prospects remain bright. And business investment should remain solid, with drilling and mining bolstered by increased oil prices. Moreover, the sizable fiscal stimulus that is in train is likely to provide a tailwind to growth in the second half of the year and beyond.2 From a position of full employment, the economy will likely receive a substantial boost from $1.5 trillion in personal and corporate tax cuts and a $300 billion increase in federal spending, with estimates suggesting a boost to the growth rate of real GDP of about 3/4 percent this year and next.3
Summary
The turmoil in Italy over the past two weeks contributed to a repricing of Fed tightening expectations, knocking a full rate hike off the table by Wednesday. Relatively hawkish comments by Lael Brainard and other FOMC officials cast aside any thoughts that events in Italy would alter the course of Fed policy. Anyone hoping a Fed hesitation would breathe new life into emerging markets will be disappointed.
Comment
The Morgan Stanley Implied Pace of Rate Hikes Index measures the expected number of rate hikes over the next 12 months. Over the past two weeks, the index was halved, falling from a peak of 2.8 to just 1.4 on Tuesday. A June rate hike remains a lock and the consensus is that September will bring another rate hike. The potential for a December rate hike has been the question all year. The drop in the implied pace of rate hikes suggests it is off the table.
Lael Brainard’s remarks emphasized two key points and helped put a floor under Fed tightening expectations for the rest of this year. She emphasized two points, the expected impact of large fiscal stimulus while at full employment, and a willingness by the FOMC to raise the policy rate above its long-term neutral level. Long story short, the Fed is on track for 2 and maybe 3 more hikes this year. We think expectations will continue to reverse their sharp decline.
This hasn’t stopped a few commentators from reflexively pointing toward a Fed hesitation as a boost to emerging markets. We don’t expect that to be the case. The chart below shows the relationship between standardized, concurrent 3-month changes in FOMC rate hike timing and 3-month total returns for MSCI emerging market equities index by year. The relationship is unstable and has nearly vanished in 2018.
FOMC rate hike timing is among a series of variables we considered in a generalized additive model to illustrate their effects on equity returns across emerging market countries. The chart shows the influence of 3-month changes in implied rate hike timing on expected 3-month equity returns. The hashed, vertical orange line reflects the latest 3-month change in rate hike expectations.
The drop in rate hike expectations we’ve seen in the past two weeks is insufficient to drive expected equity returns higher in any of these emerging markets. Markets would need to begin doubting the September hike to move the needle.
If concerns about Europe or other matters escalate enough to make the Fed change course, Russia, the Czech Republic, Chile, Colombia, and Malaysia are the countries most likely to see tailwinds for equity performance.
Conclusion
Brainard’s comments yesterday reaffirmed the Fed’s plans to raise the fed funds rate at least two more times this year. Markets have taken December off the table for now, but the Fed remains steadfast in its views about the impact of fiscal stimulus at full employment. Brainard’s comments about tolerating an inversion of the yield curve and raising rates above their long-term neutral level signal the strength of their resolve. Emerging market equities will find no relief from the Fed.