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Aon Retirement and Investment Blog

When will the Fed stop hiking rates

Executive Summary

The rhetoric from US Federal Reserve (‘Fed’) officials has become notably more dovish ahead of the next policy meeting (18th/19th December). Whilst we still think that the Fed will hike this week, we expect the guidance in the 'projection materials' and the rhetoric at the press conference to be significantly more 'dovish'. We believe the Fed will hike once, probably in March, and then go on a long pause.

The strength of US growth is currently tricky to assess. Although November's payroll numbers were on the weak side, manufacturing ISM for November was strong. It would be unusual for manufacturing to be this robust if a recession was imminent. Overall, the data suggest a deceleration to trend rather than an imminent recession.

A pause in rate hikes next year is already priced by rates markets but is perhaps less understood by risk asset markets. We would emphasize, that a pause is not necessarily a stepping stone to cuts. It could extend the cycle and push out the date of the next recession out. A pause could cause the economy re-accelerate, and mean that the Fed could return to hiking in 2020.

The Fed versus markets expectations for the path of Fed Funds

The US Federal Reserve’s interest rate setting committee, the Federal Open Market Committee (FOMC), produces a summary of their projections every quarter. This shows the FOMC participants’ views of how they think the path of the US economy will evolve and where they think the Federal Reserve’s Fed Funds target rate (the policy interest rate that they set) should be. The projection is conditional on:

  • appropriate monetary policy being followed
  • the absence of any shocks.

The 'dot plot', as these projections are known, is not the be all and end all of the Fed's communications on rates. They're very keen to emphasize that these are conditional forecasts, and they're subject to considerable uncertainty, particularly at longer horizons. Markets are pricing in just one hike next year (assuming we get a hike next week).This is versus three further hikes implied by the median of the dot plot. The market then assumes that the Fed is on hold through 2020 whereas the dot plot suggests another hike. If we believe the 'modal' (the most popular) dot corresponds to the vote of Chair Jerome Powell then there will be two further hikes.

FOMC Dot Plot implies further increases of the Fed Funds over 2020. The market is not convinced.

The chart below shows the implied probabilities[1] of different target ranges for the Fed Funds target rate following the final FOMC meeting of 2019. It compares that to the levels implied by the FOMC dots. Markets are putting only a very small chance on the median FOMC scenario occurring.

Implied probability of where the Fed Funds Target rate ends 2019

Powell and the Neutral Rate

Chair of the Board of Governors, Jerome Powell's rhetoric has been far more dovish in recent weeks than it was back in the summer. At a speech on the 28th November he stated that rates were 'just below the broad range of estimates of the level that would be neutral for the economy'. With financial market volatility likely to act as an additional headwind to an already slowing economy at the margins, this would suggest that the Fed is nervous about hiking too much too soon and may be moving towards a 'pause' mode. What does Powell mean by the neutral rate? Definitions and estimates of the neutral rate vary but it is usually estimated in real (that is after inflation is taken away) terms. It is typically defined as the rate which keeps the economy growing at trend when it is already at full strength.

The New York Fed's Estimates of Neutral Real Rates 

The chart above shows the New York Fed's estimates of the neutral real rate for four major monetary areas. For all four, these neutral rates have been on a downward trend. For the US the neutral real rate is estimated at around 0.5%. Add 2% for the desired inflation rate, and you arrive at a nominal neutral rate of 2.5%.

In a speech back in September, John C. Williams, President of the New York Fed, argued that markets were paying too much attention to these estimates of the neutral rate, and not to expect the Fed to stop once estimates of the neutral level were reached as there was a huge range of possible neutral rates. Instead they would focus on how well the economic data were performing, to decide whether to keep increasing rates or not. Powell also followed up with hawkish comments in a press conference on October 3rd, where he suggested the Fed was 'a long way from neutral, probably'. We think these hawkish comments added to market volatility first in bonds and then in equities in October. Whilst we don't think that the Fed are prevented from acting by financial market volatility, a combination of volatility and decelerating economic data will make them cautious.

Slowing but positive growth

The US economy is certainly slowing. After hitting a peak growth rate of 4.2% in Q2, it slowed to 3.5% in Q3 on the back of weaker trade. It has likely fallen to around 2.5% this quarter as private investment has slowed. (Q3 investment strength was largely due to inventory building rather than fixed investment and was in part driven by frontloading ahead of trade tariff increases).

In the latest employment data the unemployment rate stabilized at 3.7%. However, broader measures of underemployment, such as the U6 unemployment rate which includes discouraged, marginally attached, and part-time only for economic reasons workers rose to 7.6% from 7.4%. Weekly wage inflation also moderated, with a slight fall in the average weekly hours worked. The payrolls figure, which is perhaps the most watched US economic number, also fell short of expectations. Though the hurricanes in October and September made forecasting this number difficult, it is tricky to know how much payrolls were impacted by the storms in these months and how quick any bounce back will be. Whilst we do not read too much into one set of numbers, overall the data suggests a picture of an economy now growing close to trend.

The weak employment numbers have led to a reduction in econometric 'nowcast' models of Q4 GDP growth. These models attempt to replicate the individual components of GDP and use only economic data rather than judgement to forecast the current GDP growth rate.

Q4 GDP growth likely to be substantially slower than Q2

The weakness in wage inflation, whilst giving some more wiggle room for the Fed, also needs to be recognized in the context of being a very volatile number. We would emphasize though that even if wage inflation does bounce back, it is not clear this will necessarily cause higher consumer price inflation. 

Profit share of output still above long-term trend average

The chart above shows various measures of company profitability as a share of 'value added' (this can be thought of as the GDP of a company: its revenue minus all non-employee costs). The chart is expressed in net terms (i.e. after allowances for depreciation have been made). Because these shares are higher than historical averages, it suggests there is some room for companies to potentially absorb higher wages without necessarily passing them on as higher prices. Whilst that doesn't mean higher wages won't be passed on, it means that the reliability of wages as a leading indicator of price pressure is reduced. The chart below shows the two main measures of US inflation: the CPI (consumer price index) which measures a basket of goods and services, that an average household buys, and the PCE (personal consumption expenditure) deflator, which is based on the national accountant's estimates of what the household sector consumes. Both these measures come in two flavors, headline and core (which excludes food and energy).

Inflation not obviously a problem for the US economy

The chart above suggests that inflation is not much of a problem. The Fed's preferred measure of inflation is the core PCE. This looks to have rolled over and was below 1.8% YoY in October. Whilst this is only slightly below the target level of 2%, the deceleration may make the Fed more cautious. Core CPI for November accelerated slightly from 2.1% to 2.2% YoY. We think that this is sufficiently solid to justify an increase next week, even if the Fed goes on to pause rate hikes next year.

Will the Fed dare to invert the yield curve?

Another reason to anticipate a pause is the danger that if the Fed keeps hiking it will 'invert the yield curve' and this could unnerve markets. Yield curve inversions mean that longer dated bonds yield less than shorter dated bonds (as opposed to the normal situation where the yield curve is upward sloping). It is typically seen as a signal of a forthcoming recession, as it suggests that Fed policy is tight and the market believes rates will need to be cut at some point in the future. In the last 7 recessions the yield curve has inverted between 5 and 16 months before the recession starts.

There are sometimes false signals. For example in 1966 when no recession occurred for over 3 years after the curve inverted. When the Fed has hiked rates despite the bond market inverting in the past it is because it has had to do so in the face of accelerating inflation. As we argued above, inflation is currently not a problem.

So should the Fed listen to bond markets or follow the dot plot? We think that they will follow the data. Our best estimate of the data is that the economy will grow at trend next year. This seems to be what the bond market is saying too. If the data becomes stronger, then we expect longer dated yields to back up and the Fed will be able to hike again without pushing short-dated rates above long dated ones.

Some economists are worried that the inversion of the 5-year vs 2-year part of the curve has already prompted discussion of whether the bond market is now forecasting a recession in the US.

The signal from bond markets may be distorted by a fall in term premia (the difference between the yield on a zero-coupon bond and where markets expect the policy rate to average out over the life of the bond). Term premia has likely been depressed by expanded central bank balance sheets, which increased after the financial crisis because of quantitative easing (QE).

Historically, when the 10-year yield went below the 2-year yield this would typically mean that markets would expect significant interest cuts after 2 years even if the curve was only slightly inverted. For a recession signal now, we think that there has to be a bigger yield curve inversion. According to one methodology, the 10-year term premia has fallen 0.3% since 2007 (when the yield curve inverted before the financial crisis). If these estimates of term premia are correct this would mean the 2-year would have to yield at least 0.3% more than the 10-year in order for the signal to be equivalent to the 2007 one.

However, estimates of term premia, are highly uncertain. It would therefore take a brave Fed to hike rates above where 10 or even 5-year bonds were trading unless they were forced to do so by a rising inflation outlook. Until Treasuries yields rise, this suggests that the Fed has a maximum room of only two more hikes.


A pause in rate hikes at some point in 2019 seems quite likely. However, this is conditional on the slower growth and subdued inflation environment remaining in place.

We think that markets could perceive a pause as a goldilocks scenario, creating a bounce for risk assets. However, we caution that it wouldn't mean that we were necessarily returning to a bull market. If wage inflation was to start to come through it could be at the expense of profits, which would unsettle equities. If profit margins are maintained it would suggest that core inflation would start to reaccelerate again, and that bond markets would be unsettled.

This might mean the Fed is forced to return to hiking rates by the end of 2019 or in 2020, with the Fed funds rate having to go too far higher levels than it would have otherwise. We therefore believe we will remain in a transition environment bouncing between optimism and pessimism, so that both equity and bond returns will remain volatile.

Derry Pickford is a Principal on Aon’s Global Asset Allocation team, and is based in London, UK.

[1] Options give us the price or 'risk neutral' probability of an outcome rather than the true probability. As with all forms of insurance the cost of the option, when it gives a pay-out in a 'bad scenario' will be higher than the actuarial cost, and so the implied or 'risk neutral' probability will be higher than the true probability.

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