Until recently, we expected the US Federal Reserve to increase interest rates in December, followed by two more hikes in 2018. Now, however, we forecast four hikes in 2018. There are several reasons for this change.
First, the US economy appears to be growing above potential. Our nowcast (which attempts to measure real-time growth by combining a range of other indicators) is consistent with growth of 3.9% annualised in November, compared to our estimate of 2% trend growth.
Source: Aberdeen, Thomson Reuters Datastream, October 2017
This follows on from third quarter growth that was surprisingly strong at 3% annualised. This represented back-to-back quarterly growth in excess of 3% for the first time since 2014.
Solid growth in jobs
Furthermore, the US labour market rebounded from hurricane disruptions, with a solid gain of 261,000 jobs added in October. The unemployment rate fell to a 17-year low of 4.1%, a rate that is already below most estimates of full employment. The above-trend growth puts further downward pressure on the unemployment rate; clearly there is a risk of an overheating labour market.
On top of this, it looks probable that Congress will pass tax cut legislation. Congress has already passed a resolution calling for a $1.5 trillion net tax stimulus. However, there are still significant implementation risks around passing the Tax Cuts and Jobs Act. A key problem is the fact that the Republicans only have a wafer-thin majority in the Senate, and so require near unanimity to pass legislation. This raises questions about whether the tax cuts that have been tabled will be passed unscathed.
Any stimulus that does result from the Act should boost near term growth, but over the medium term it doesn’t necessarily map to a much stronger economic outlook. It may instead cause higher interest rates and potentially lower growth as the Fed moves to offset the demand boost.
Output gap has closed
For much of the post-crisis period, the US has had a large output gap. In this situation, a sustained period of above trend growth is required to close the gap. As such, monetary and fiscal easing represent something akin to complements, as anything that boosts demand is largely welcome. However, with US unemployment having fallen so low, the output gap is probably closed. Any boost to demand that takes growth above potential would be inflationary. Monetary and fiscal policies become substitutes, with easier fiscal policy requiring the central bank to offset this with tighter monetary policy – again, strengthening the case for rate hikes.
With unemployment having fallen so low, the output gap is probably closed.
It is possible that certain tax cuts could also boost potential growth, which limits the extent to which the Fed would have to offset the demand boost. However, it is hard to believe the current tax proposals will materially improve the supply side.
Finally, even as the Fed has hiked rates and started running down its balance sheet, financial conditions have not tightened – equities and credit markets have been well supported, and the dollar has weakened over the year. While we cannot observe the counterfactual – it is likely that financial conditions would be even easier in the absence of hikes – this should concern the Fed. After all, the purpose of hiking rates is to tighten financial conditions. Therefore, the Fed may need to increase interest rates more rapidly to bring about the desired tightening in financial conditions.