Wednesday, May 3, 2017

Modest Fed expectations fit with modest growth

Today's FOMC statement was pretty much as expected, to judge from the relative lack of reaction in the bond market. The market currently assigns a relatively high probability of a modest 25 bps hike in the overnight funds rate target at the June FOMC meeting, and a very low probability of another for the remainder of the year. This fits with the current economic growth climate, which remains modest. Second quarter GDP is likely to be much faster than first quarter (0.7%), according to the Atlanta Fed, but the underlying rate of real growth is unlikely to be much faster than 2%. 

The chart above says just about all you need to know about current expectations. The blue line is the current real Fed funds rate (about -0.6%), and the red line is the market' expectation for the average real Fed funds rate over the next 5 years. The difference between the two is quite modest—just over 50 bps—which suggests the market just doesn't think the Fed is going to do much more tightening after next month's meeting for the foreseeable future. I note that the blue line has moved up of late, and that reflects the fact that the Fed's target rate has moved up from 0.25% to 1.0% while core PCE inflation has remained relatively stable at 1.5 - 1.8%.

In many previous posts I've noted that the time to worry about the Fed being too tight is when the blue line equals or exceeds the red line. At that point the market is figuring that the Fed is done tightening because the economy is softening and at risk of recession. Currently that's not the case. But neither is it the case that the market expects much more oomph from the economy.

If the market were optimistic about growth, the gap between the blue and red lines would most likely be much bigger, and the red line would be much higher (real interest rates tend to follow real growth rates). That's not likely to happen unless and until Trump manages to achieve some meaningful tax and regulatory reform. For the time being, the world is on hold.

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