As 2018 gets rolling, markets don’t have great expectations for Fed interest-rate hikes. Based on futures pricing, roughly two small increases are anticipated this year. We think there will be more.
In our view, several economic and policy factors are converging that could pave the way for four 25-basis-point hikes in 2018, pushing official short-term rates up by a total of 1% for the year. Here are five things that tell us the market is coming in on the low side:
1. The economy is rolling along. US gross domestic product grew by more than 3% in annualized terms over the final nine months of 2017 and the momentum has carried over into 2018. A strong economy makes rate hikes more likely, in order to prevent overheating. Run the economy too hot for too long, and there’s a good chance inflation will exceed acceptable levels. A vibrant economy should also make the Fed more confident that raising rates won’t derail the expansion—just slow it to a more sustainable pace.
2. Inflation pressure is rising. Year-over-year core inflation, which excludes food and energy, is still well below the Fed’s 2% target. However, pressure is rising below the surface. Six-month annualized core inflation has already topped the 2% mark and is rising (Display). Many factors that continue to hold down the year-over-year reading are likely to dissipate over the next few months. And rising oil prices offer more evidence to support our expectations for higher prices.
3. Financial conditions have gotten easier—not tighter. When financial conditions are easy, households and businesses have ready access to cheaper funds to fuel consumption or investment. When a central bank raises rates, it’s an effort to tighten conditions—to slow the economy and keep inflation contained. The Fed has hiked rates four times since December 2016, but financial conditions have actually eased (Display). That’s great for growth, but the Fed is probably starting to worry about too much of a good thing.