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 Fed’s
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%.
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