Goldman: “It Is Possible The Fed Does Five Hikes This Year”

It took the market about 30 minutes to read today’s FOMC minutes, and realize that despite the post-FOMC kneejerk narrative which “found” the minutes to be dovish if only to justify the jump in stocks, the Fed was decidedly hawkish, and may well be looking at the higher number in the ongoing debate whether it will hike rates 3 or 4 times in 2018.

To some, such as IHS Markit Executive Director Ken Matheny, the Fed was clear enough, and the economist revised his FOMC forecast up to 4 rate hikes this year after the report.

Relative to forecasts submitted in December, Committee members generally revised up their expectations for GDP growth in response to looser financial conditions and expectations of stimulus from the tax cut. They agreed that a stronger near-term outlook increased the likelihood that a gradual upward trajectory for the federal funds rate would be appropriate.

The discussion in the minutes was consistent with our forecast that the FOMC will raise the federal funds rate several times in 2018 as it seeks to balance the risks of too low inflation against overheating and financial excesses. We continue to expect a total of four rate hikes in 2018, with the next hike at the upcoming meeting on March 21.

And while 4 rate hikes will certainly be frowned upon by the market, it will hardly be disastrous: after all, that has long been the baseline case of some of the more hawkish banks, such as Goldman Sachs.

What was more surprising, however, is what Goldman said shortly after the minutes were released: in a podcast with David Mericle, Goldman’s senior US economist reiterated his expectation for four rate hikes this year, adding that the risk is not to the downside, but rather higher, predicting that “by later in the year, it’s certainly possible that they wind up adding another one and do five hikes for the year”, with the fifth hike taking place during a non-press conference meeting.

Needless to say, 5 rate hikes would send the short end just shy of 3%, and assuming the 10% remains roughly where it is, flatten to the yield curve to a pancake, beginning the countdown to the next recession. It would also have a very adverse effect on the stock market, where i) the equity risk premium is rapidly collapsing, and where ii) if the short end offers the same yield with a fraction of the duration risk, well investors will promptly move “up in quality while reducing duration” as Guggenheim’s Scott Minerd observed earlier today.

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Below is the key excerpt transcribed from the just released Goldman podcast, highlights ours:

Marina Grushin: Welcome to the Top of Mind podcast. I’m Marina Grushin. Inflation worries and rising rates were among several factors that jolted equity markets out of complacency earlier this month. Yet equities have largely looked through last week’s upside surprise in core CPI, which increased at the fastest pace in 12 years. Goldman Sachs economists see this as part of a rebound in inflation that will continue alongside quarterly Fed hikes. So how easily will risk assets digest these developments over the coming weeks and months?

Joining us today to discuss the inflation path and the risks around it is David Mericle, Goldman Sachs senior US economist.

David, thanks for joining us. You’ve been calling for a pickup in wage and price inflation for some time now, and the latest data have shown signs of reacceleration… but these numbers can be volatile. So what makes you think that inflation is now on a more sustainable upward trajectory?

David Mericle: I was admittedly surprised by the soft inflation data last year, but I think it would be a mistake to make too much of it. Over the course of 2017, the market bought hard into the claim that inflation was just structurally lower for one reason or another, whether it was the alleged effect of globalization or of Amazon or whatever. We have been very skeptical of these stories, which, in my view never had a whole lot of evidence in their favor. And I think the weakness last year, in the end, was largely idiosyncratic and transitory and didn’t tell us anything profound or new about the inflation outlook.

I do see the latest wage growth and inflation news as encouraging, but I think it would be equally wrong to get too carried away at this point in expecting a very rapid acceleration on the basis of a couple of prints. In a labor market that is likely to see historically low levels of unemployment in the coming years, both wage growth and inflation are likely to gradually move higher.

But that’s just one part of our 2018 inflation forecast. On top of conventional Phillips Curve effects, we also expect boosts to core inflation from higher energy prices, from dollar depreciation, from the fading impact of the ACA on healthcare inflation and from the dropping out of some unusual downside base effects last year. Each of these should contribute a bit to pushing inflation closer to the target by the end of the year.

Marina Grushin: And you’ve now upgraded your year-end core PCE forecast by 0.1pp to 1.9%. At this point, are the risks around that tilted to the upside or the downside?

David Mericle: I think there are risks in both directions, though I would say that the risks to the upside were, at least until very recently, quite underappreciated in financial markets. Last year some unexpected weakness emerged in categories that just aren’t that cyclical. In recent research, we found that the historically cyclical categories of core inflation have largely picked up as expected, while the acyclical categories lagged last year. But the reality is that a pretty large share of the core consists of categories that largely follow sector-specific trends rather than broader cyclical trends, so I think those categories in particular always present risks in both directions.

In thinking about upside risks, I think the key question is whether we should expect to see an inflection point as the labor market gets extremely tight. It’s a hard question to answer looking at the aggregate inflation data because we really only have two good historical examples of this—the late 1960s and the late 1990s—and they turned out very differently, and they both differ in important ways from the current situation. But if you look at city-level inflation and wage growth data in the US, you actually have a lot more examples. And looking at that data, we’ve found that there does seem to be a bit of a kink in the Phillips Curve at very low rates of unemployment—rates below 4%. So I think there is an upside risk to our forecast, and I think even now the market might not fully appreciate it.

Marina Grushin: The concern with that upside risk, of course, is how it might influence the Fed. In your view, what would have to happen for the Fed to tighten policy more aggressively?

David Mericle: We expect them to hike four times this year. They wrote down three hikes in their December dot plot, but that projection, in my view, already felt a bit dated at the time and not really in sync with their economic projections. It feels even more dated now that the fiscal stimulus has grown and the inflation and wage data have finally shown signs of life. So, let me consider our four hike scenario as the baseline here, and I would say that I see risks around our forecast as two-sided as well. I doubt that they would hike at a non-press conference meeting in the first half of this year; it just doesn’t seem necessary yet. But by later in the year, it’s certainly possible that they wind up adding another one and do five hikes for the year.

I don’t see higher inflation as the most obvious catalyst for picking up the pace, at least not in 2018. I don’t think that core inflation is likely to be meaningfully above 2% by year-end, and even if it were moderately above, after so many years of below-target inflation, I don’t think Fed officials would be particularly anxious about being a bit above their target, which is symmetric after all. Instead I think signs of labor market overheating are more likely to create enough anxiety at the Fed that they feel the need to pick up the pace. If the unemployment rate falls to the level we expect—3.5% by end-2018—if the economy shows no signs of slowing down, and especially if they were to again seemingly fail to get traction over broader financial conditions, as occurred in 2017, then I think under those circumstances it would be very natural to consider acting more aggressively and picking up the pace.

via Zero Hedge http://ift.tt/2ogGl1S Tyler Durden

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