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Powell opens door to further rate hikes

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Investment Banking Essentials: February 21

Powell opens door to further rate hikes

Hinting at what investors and economists perceived to be a more hawkish approach than his predecessor, Federal Reserve Chairman Jerome Powell told a congressional committee that he may revisit how many rate hikes he would recommend in light of stronger recent economic data.

"My personal outlook for the economy has strengthened since December," Powell said, speaking to the House Financial Services Committee on Feb. 27, in connection with the Fed’s semiannual "Monetary Policy Report" to Congress.

At their December meeting, Federal Open Market Committee members had projected a median of three rate hikes in 2018, but that was before Congress passed a major tax cut bill and agreed on a budget. The first rate hike this year is widely expected in March.

The potential for even more rate hikes drove equity markets down following Powell’s testimony. The S&P 500 Index closed down 1.27% at 2,744.28, while the Nasdaq Composite Index closed down 1.23% to 7,330.35.

Yields on the benchmark 10-year Treasury rose four basis points to around 2.90%. The dollar strengthened, with the New York Board of Trade Dollar Index up 0.63% to 90.42.

Market reaction

Powell’s optimistic take on the economy came as something of a surprise to market participants.

"Heading into [Powell’s] testimony, I would have argued he was a centrist who was balancing risks on the downside and upside," said Joseph Song, senior U.S. economist at Bank of America Merrill Lynch.

Powell’s testimony, however, "suggests a risk that he will revise his dot up," Song said, referring to the dot plot that FOMC members use to indicate where they think rates will be in the future.

Some economists believed Powell’s review of economic conditions supported their forecasts, with James Knightley, the chief international economist at Dutch bank ING projecting four rate hikes in 2018, starting in March. That prediction was based on Knightley’s "above-consensus 3% GDP growth forecast for 2018 and the potential for inflation to rise more quickly than many in the market anticipate," Knightley said in a research note issued before Powell’s live testimony.

Powell also said that "the next couple of years look quite strong" and that the U.S. "should see strong demand from consumers and businesses to invest," with concurrent labor market improvement and increased inflation.

That dynamic would support more rate hikes in 2019, contrary to market chatter that the Fed might raise rates this year and then pull back in 2019, said John Silvia, chief economist at Wells Fargo.

Inflation expectations

While Powell acknowledged that inflation had remained below the Fed’s 2% target, he insisted in his prepared remarks that "further gradual increases in the federal funds rate" would be the best way to promote the central bank’s dual mandate of full employment and price stability.

Like his predecessor Janet Yellen, Powell said the "shortfall" in inflation was likely due to "transitory influences."

He also brushed aside suggestions from elected officials that the Fed should change its approach to inflation targeting, saying "our current approach seems to be working very well." The 2% target rate is "now the global standard" that "oils the wheels of the economy and gives the central bank room to cut," making it hard to change.

"This suggests there are a lot of varying views [on the FOMC] around policy frameworks," Song said. "Personally, Powell may be skeptical about going to another framework like nominal GDP targeting or price-level targeting, so if there’s going to be a change, it will take quite a long time."

In response to questions about whether the Fed should consider selling mortgage-backed securities to hasten the normalization of its $4.5 trillion balance sheet, Powell stressed that he liked the current plan of passively allowing assets to mature.

Change at the top

Though Powell’s take on the economy came across as more hawkish than Yellen's, economists viewed much of his response as keeping with his predecessor’s approach.

One difference between the two is that Powell expressed more willingness to ease regulations, especially for smaller institutions, Song said.

Nonetheless, like Yellen, Powell faces the conundrum of historically low unemployment — currently at 4.1%accompanied by lower-than-expected inflation and wages, Silvia said. Given that, Silvia expects the Fed chairman to remain as data-dependent as his predecessor. That is in contrast to some economists, and many Republican elected officials, who have called for the Fed to use a rules-based approach.

One significant data point is due next week when the U.S. Department of Labor releases the February unemployment rate March 9.

That should be the first test for the new Fed chairman's prediction that the economy is still expanding and putting upward pressure on wage growth, Silvia noted.

"If it reinforces the January hourly wage growth, then you'll probably see an increased likelihood of four rate hikes in 2018," he said.