Long considered a dove, Federal Reserve Bank of Chicago President Charles Evans Friday expressed comfort with the inflation outlook and repeated his belief rates will become slightly restrictive. That led some observers to ramp up concern about the flattening yield curve.
If projections are correct, gradual Federal Reserve rate hikes should continue and policy will eventually become “mildly restrictive,” Evans said at a forum in Fort Wayne, Ind., according to prepared remarks released by the Fed.
“I expect the strong fundamentals for growth to continue and inflation will reach our symmetric 2% target on a sustained basis,” he said. “Given this outlook, it is time to return to the more conventional, mainstream monetary policy that characterized the Fed’s policymaking in the 20 years prior to the financial crisis.”
Evans sees GDP growth “in the neighborhood of 3%” this year and somewhat slower in 2019 and 2020, “as the fiscal bump wears off.” The unemployment rate will fall to about 3.5% by the end of 2020, he said, noting that’s almost a percentage point below his staff’s estimated natural rate.
“I am more comfortable with the inflation outlook today than I have been for the past several years,” he added. Core inflation “has been running close to 2% since last March.” He sees inflation growing “a bit further over the next few years,” consistent with the Fed’s symmetric 2% target.
Evans said his view of the economic outlook “is generally in line with” the Federal Open Market Committee’s projections. “In other words, we are more or less singing the same tune.”
Tom Essaye, founder of Sevens Report said the takeaway from Evans’ and other FOMC members’ recent comments is to expect more flattening and, eventually, inversion of the yield curve, which has historically signaled an upcoming recession. “Evans’ comments, combined with more expected Fed rate hikes, will send the short end of the curve lower/yields higher, but the bond market is not selling the long end of the curve because, despite the Fed’s growing confidence in the economy, the bond market is showing serious doubts about future growth and inflation,” Essaye said.
"The Evans speech sounds a little hawkish, and is consistent with recent comments from others such as [Fed Gov. Lael] Brainard and [Atlanta Fed President Raphael] Bostic," according to Rich Sega, global chief investment strategist at Conning. "They want the market to believe [the Fed should be forward-looking in keeping the economy from overheating and reducing the threat of asset bubbles building], and to believe that the threat of inflation is not huge, but greater than the market seems to be measuring today. So far, bond investors haven’t really taken the bait as there’s not much of an inflationary expectation premium built into the UST curve…very flat and not very volatile.
"If and when the bond market starts to believe the story, I expect the UST10yr yield to creep above 3% and the yield curve to steepen from cash and from 2 years out to ten," Sega added. "But I don’t expect Evan’s speech nor the rate increases now and in December to ignite a spike in rates as global demand for yield and duration will be able to absorb it. This should lead investors toward somewhat shorter duration targeting, and raise interest in floating rate types of assets. But not a fire sale of bond mutual funds nor a bursting bond market bubble."
While Evans considers risks “balanced,” he noted rate hikes are data dependent and “unexpected tailwinds” could potentially push the economy past “sustainable growth and employment levels,” forcing the Fed “to tighten somewhat further.” And conversely, “unexpected headwinds” could result in a less restrictive policy.
“Although sounding hawkish on inflation, he also sounds hawkish on disinflation or on a general economic slowdown, as he mentions they stand ready to implement alternative accommodative measures if needed again,” according to Kevin M. O’Brien, founder and president of Peak Financial. "I believe the bond market has priced in the next couple of Fed rate hikes as they've been fairly transparent about their future rate moves.” The Fed is expected to raise rates twice more this year to a range of 2.25 to 2.5%, and then twice more in the first half of 2019, according to Bryce Doty, senior vice president at Sit Fixed Income Advisors. “Our forecast may be too low though after two members of the Fed have now cautioned that they may need to raise rates above the neutral rate.”
While Evans' talk of a return to “conventional monetary policy making of yesteryear” could be seen as portending "a more hawkish, aggressive rate hiking Fed," according to Stephen J. Taddie, managing partner at Stellar Capital Management, LLC, "throughout his speech he reaffirmed that the level of rates now and in our foreseeable future will remain lower than in the past, due to global and U.S. conditions, and that other policy tools will come in to play more often as we attempt to stay away from the Effective Lower Bound (ELB) of the Fed Funds rate. The discussion regarding the impact of being at, or going below the ELB, combined with comments about the global economic environment was telling."
Stifel Chief Economist Lindsey Piegza is skeptical about rate hikes after one expected this month. “[W]ith still-far from impressive wage growth, let alone concern of the domestic economy overheating, rising risk of curve inversion as well as a recent relief in prices, the Fed will have a difficult time justifying an additional rate hike come year-end.”
“The Fed seems likely to continue gradually hiking rates given that financial conditions have not started to tighten much and given that the Fed views the neutral policy rate as being around 3.00%,” according to Merk Research. “The 2s10s U.S. yield curve looks likely to invert later this year or early next year.”
