Probability of a Fed Rate Hike in March, 2018 is 92.3% by Hongcheng Chen, Creative Investment Research



New Federal Reserve Chairman Jerome H. Powell (above) showed up at the Rayburn House Office Building on February 27 to deliver his first semiannual testimony before the Committee on Financial Services. Before he dug into the details of monetary policy, Powell described the outlook for the U.S. economy as bright and robust: “The U.S. economy grew at a solid pace over the second half of 2017 and into this year.” setting an optimistic tone for his interpretation of the current economy and prospects for the future. He emphasized that U.S. economy, from his perspective, is getting  better, stating that, “my personal outlook for the economy has strengthened since December.” Apparently, the new Chairman of the Fed has full confidence in this country’s economy despite the Dow Jones’s plunge of more than 600 points in the same month.

Economic Outlook

Here are some highlights from Powell’s testimony.

   Labor market: job growth since last year has been solid enough to lower the unemployment rate to 4.1%; labor market strength allows for a stable labor force participation rate; unemployment rates for African American and Hispanics are at record lows, last seen prior to the recession.

   GDP: the annual growth rate of inflation-adjusted GDP was 3% in the second half of 2017; there was a surge in business investment last year; manufacturing has been supported by growing demand for U.S. exports.

   Inflation: inflation has stayed at less than 2%; the inflation rate on personal consumption expenditures (PCE) rose by 1.7% last year, roughly the same as 2016; core PCE (energy and food items excluded) increased by 1.5% last year, lower than in 2016.

Monetary Policy

Powell then described the details concerning monetary policy. First, he noted that the target range for the federal fund rate was raised to 1. 25% to 1.5% at the Feds December meeting. The balance sheet normalization program has been going well since October. This reduction in monetary policy accommodation will, according to Powell, enable the labor market to retain its strength and keep the inflation rate at 2%.  Ultimately, the Fed’s monetary policy goal for the next few years is to reach a balance between avoiding overheated economy and pushing the inflation rate to a sustainable 2%.

The new Chairman talked about the strength of labor market and the balance between an  overheated economy and the inflation. Powell believes that investors’s concerns related to recent market volatility are somewhat reasonable, not impulsive. Even though he said he would not “prejudge” whether the fed fund rate will be increased four times by the end of 2018, (which makes a lot of sense when your words can stimulate huge volatility and turbulence in the market) his optimistic and confident comments may send a signal to the market that the rate can be raised more than 3 times in this year.

Wall Street seems to have foreseen the path of fed rate hike. Goldman Sachs[1] believes there could be 4 rate hikes in 2018 and that the probability of a March rate hike is over 95% .

   Tax Overhaul Adds to Inflation Pressure.

The tax cut bill has been in the spotlight since December. On December 22, President Trump signed the GOP tax bill and encouraged companies to share the resulting massive benefits with their employees. Walmart [2], for example, is sending a $ 1,000 one-time bonus to more than 100 million hourly associates and raising the minimum wage to $11 because of the cut. Certainly the tax overhaul will sharply increase household wealth and spur the consumption of goods and services. 

An increase in inflation may not be avoidable in this case.  According to Bureau of Economic Analysis, the growth of core PCE from December 2017 to January 2018 is 0.271%, higher than the 0.167% from November 2017 to December 2017. Clearly, the inflation has been growing at a faster pace since the tax overhaul and raising the fed rate may help the fed reach their inflation target. 


   Economic growth provides a solid base.


We don’t need to repeat how well U.S. economy is doing right now, since Powell gave copious  detail concerning economic, labor market and production growth. Apparently, the 3% of projected GDP growth rate, declining unemployment rate, growing manufacturing industry and increased wage level will allow the fed to have great confidence that the economic outlook is robust enough to handle more rate hikes. In the extreme case, if the economy is in danger of “overheating”, rate hikes become a “must have” rather than an option.

   Balance sheet normalization may be one of the rate hike drivers.

The fed started to purchase vast amounts of MBS after the financial crisis with the goal of reducing interest rates and spurring business investment. According to fed, as of February 2, 2018, it holds total $1.759 trillion in MBS [3] and $2.424 trillion in U.S. treasury securities[4]. Powell stated that balance sheet normalization is important in sustaining the strength of the labor market and reaching the fed’s target inflation rate.

For several reasons, balance sheet normalization may accelerate in 2018. Donald Trump was not a big fan of the “Quantitative Easing” program when Janet Yellen was Chair of the Fed. Powell holds a decidedly optimistic view of the current economic situation and potential for future economic growth.  Thirdly, the House Financial Services Committee’s concern about the Fed’s balance sheet seemed to indicate an inclination toward more aggressive action. The Committee was not satisfied with the Fed’s actions of simply not reinvesting principal, and seemed to be pushing for sales of the securities.

According to the FOMC (Federal Open Market Committee) statement of December 2016, the Fed will not start to rundown their balance sheet until “normalization of the level of the federal funds rate is well under way.” Guess what, actions to normalize the balance sheet may drive Fed rate hikes. We will see.

   Other Recent Factors.  President Trump said on March 1 that he would impose a 25% tariff on imported steel and 10% on aluminum. This will elevate the price of manufactured goods made of steel and aluminum, exacerbating the inflation rate and elevating the number of rate hikes. There will be more unforeseeable impacts from the Trump administration.

In nutshell, there are now more reasons for the Fed to raise the federal funds rate more than 3 times, as in 2017, thus, predicting 4 rate hikes is moderate and appropriate in this case.

Fed Rate Hikes in March? Our probability model.

The probability of Fed rate hikes in March is closely related to the performance of several economic indicators specifically mentioned by Powell in his testimony. Since the performance of those indicators will affect the Fed’s decision to raise rates, below I review selected economic indicators. I run a logistic regression to estimate the probability of a rate hike based on the performance of these indicators. The indicators selected are core PCE (personal consumption expenditure), Housing Starts, Inflation Expectation, Civilian Employment Level, Employment Rate of the population aged 25-54 and the Civilian Labor Force Participation Rate.

I randomly selected 30 rows of data as the test data and the rest as training data to generate the logistic regression model. (When using the data in March for those indicators to predict the  probability of a rate hike, I make an assumption that the growth rate of the indicators is the same as in the last period if the real data in March is not available yet.)

The result shows a prediction accuracy of 86.6%.


The results also show the probability of a Fed rate hike in March, 2018 is 92.3%.


Even though the data analytics above may be one of the tools we can use to clear the mist surrounding the probability of Fed rate hikes in 2018, we still have to wait to see what actually happens, don’t we? Just like fiction by Stephen King, we can take every effort to clear up the mist and survive the darkness, but the ending may be astonishing and even beyond our imagination.

References:

1.Meredith, S. (2018, February 22). Goldman Sachs sees a greater than 95% chance of a Fed rate hike in March. Retrieved March 05, 2018, from https://www.cnbc.com/2018/02/22/goldman-sachs-sees-a-greater-than-95-percent-chance-of-a-fed-rate-hike-in-march.html

2.Thomas, L., & Reagan, C. (2018, January 12). Walmart to raise its starting wage to $11, give some employees bonuses following tax bill passage. Retrieved March 05, 2018, from https://www.cnbc.com/2018/01/11/walmart-to-boost-starting-wage-give-employees-bonus-after-tax-bill.html

3. Mortgage-backed securities held by the Federal Reserve: All Maturities. (2018, March 01). Retrieved March 06, 2018, from https://fred.stlouisfed.org/series/MBST

4. U.S. Treasury securities held by the Federal Reserve: All Maturities. (2018, March 01). Retrieved March 06, 2018, from https://fred.stlouisfed.org/series/TREAST

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