In case you missed it, US Federal Reserve Chairman Jerome Powell appeared before Congress on Tuesday.
This was the first time he spoke since taking the helm at the Fed at the beginning of February…
He didn’t stray far from the script.
He says the outlook for the US economy is strong.
The economy is now almost at full employment, with the unemployment rate at 4.1%.
Yet while there is solid growth in the labour market, inflation and wages have stayed low.
In fact, inflation keeps coming in below the Fed’s 2% target rate. It is now at 1.7%.
But inflation could start picking up…
Powell notes: ‘[S]ome of the headwinds the US economy faced in previous years have turned into tailwinds.’
There is a strong labour market and global growth.
But what he is mainly referring to is fiscal policy — that is, the recent US tax break. Powell continues:
‘Moreover, fiscal policy is becoming more stimulative. In this environment, we anticipate that inflation on a 12-month basis will move up this year and stabilize around the FOMC’s 2 percent objective over the medium term. Wages should increase at a faster pace as well.’
US consumer confidence is at a 17-year high. Unemployment is low. And Americans are starting to receive fatter paycheques after the recent US tax cut.
More confidence, more money, and more spending should mean higher inflation…
If the economy overheats after the tax stimulus, inflation could move higher than expected.
And it could mean that the Fed will have to raise interest rates faster than anticipated.
The December 2017 Fed economic projections don’t take into account the US$ 1.5 trillion tax boost package…or the recent budget deal that increases government spending.
The Fed will be rethinking their December projections for the March meeting.
So, things could change.
‘In the FOMC’s view, further gradual increases in the federal funds rate will best promote attainment of both of our objectives. As always, the path of monetary policy will depend on the economic outlook as informed by incoming data.’
Notice the use of the word gradual? It looks like Powell is telling the markets well in advance to prepare for more rate rises. And at the same time reassuring them the Fed won’t move too fast, so as not to spook them.
But Powell’s appearance stirred the markets nonetheless.
The Dow Jones Industrial Average has fallen over 600 points since Tuesday at time of writing.
Both the NASDAQ and S&P 500 fell by over 1.6% since Tuesday.
The US Treasury yield jumped up on the day, with the 10-year Treasury note jumping to 2.92% on talks of potentially higher rates.
Rising interest rates means the US yield curve, which shows the different yield investors receive on bonds over time, is flattening.
When asked about it, Powell said he wasn’t worried:
‘Flattening of yield curves in the past has been a sort of a precursor of recessions but largely because in many prior recessions the Fed had to raise rates quickly to hold inflation down. That’s not the situation we have now. It’s very typical for the yield curve to flatten as short-term rates come up as the economy strengthens and I don’t see a particularly large…there is always a risk of a recession at any given point in time but I don´t see it as at all high at the moment.’
What’s so important about the yield curve?
Usually, long-term debt has more risk, so yield becomes higher over time. That means the yield curve usually slopes upwards.
When long-term bond spreads get closer to the short-term bonds rate, it flattens the yield curve. The yield curve can also turn negative, sloping downwards.
What’s so important about bond yields?
Bonds are usually a good indicator of economic growth. An upward sloping yield means that outlook is good…an inverted curve could mean a recession is coming.
In fact, the yield curve inverted before each of the last seven recessions since the 1960s.
As Powell said, the Fed will keep pace in increasing interest rates and reducing money supply through quantitative tightening.
In other words, they will be doing the opposite of what they have been doing since 2008, when the Fed increased the money supply to avoid a big depression after the 2008 crisis.
The Fed needs to raise interest rates and decrease its balance sheet so that it has ammunition before the next recession.
The Fed will try to get the balance just right, to the point where the economy is not overheating but nonetheless maintaining high employment and inflation on the target rate.
But if they tighten too quickly, they could trigger a recession… something the Fed is trying to avoid.
At the same time, the US government is spending more money through tax cuts and a budget deal.
This will push up the deficit. A larger deficit means that the government will be selling more bonds to raise money…at a time when the Fed is not buying.
This should also increase spending and put upward pressure on interest rates.
How much can interest rate rises affect bond prices?
According to Charles Schwab, a brokerage firm, a bond one year from maturity will lose 1% of its price if interest rates go up by 1%.
A bond with five years remaining will lose about 5% of its price. And a bond with 30 years remaining will lose about 20%. The longer a bond has to go, the more an interest rate rise will affect it.
The Fed will try to get interest rises ‘just right’.
But things could easily get out of hand…
Editor, Markets & Money