Ben Bernanke’s Fed chairmanship was defined by the financial crisis; Janet Yellen’s, by accommodation. Jay Powell’s tenure, it appears, will be defined by normalization. At his inaugural Federal Open Market Committee (FOMC) meeting this week, Chairman Powell raised the federal funds rate by 25bps to 1.75 per cent and raised its forecast for US GDP growth in 2018 to 2.7 per cent. The Fed’s quarterly forecast indicates that they are still looking at a total of three hikes this year.
Chairman Powell, according to The Wall Street Journal, wants to balance the risk of raising rates too much against the possibility of losing credibility should the monetary authority fail to tighten quickly enough, resulting in an overheating economy and a subsequent recession in response to an overly aggressive tightening program.
To put things in perspective, the Powell Fed has a lot of ground to make up because the Yellen Fed maintained a below-market monetary policy. Historically, the benchmark Treasury yield tracks nominal GDP, which as of Q4/2017 was 4.2 per cent. Arguably, therefore, the 10-year Treasury note yield remains more than one percentage point too low thanks to aggressively easy central bank policies worldwide.
While yesterday’s rate hike was largely anticipated by the market, I believe Powell’s desire to normalize quickly is not fully priced in. As of this morning, the Taylor Rule – an algorithm designed by Stanford University economist John Taylor to set the federal funds rate – suggests the overnight interest rate should be 4.17%, nearly 10 quarter-point rate hikes above Powell’s current rate. In my view, investors should be bracing themselves for markedly higher rates as Powell’s Fed gradually reminds us what “normal” really means.