Spending Bill Raises Expectations for More Fed Rate Increases

A bipartisan spending deal reached by U.S. lawmakers earlier this month has prompted many Wall Street economists to raise their projections of how much the Federal Reserve will raise interest rates this year and next.

More forecasters say they now expect four Fed rate increases this year, up from three, because of the deal to increase federal government spending by $300 billion over the next two years.

The funding bill is more generous than many economists anticipated, and they predict it could boost U.S. economic growth in 2018 and ’19 by around 0.3 percentage points each year — roughly the same size increase expected from the $1.5 trillion tax cut signed into law by President Donald Trump in December.

Economists at UBS Group AG, Nomura Securities and Oxford Economics in the past week raised their projections for rate increases, joining other prominent forecasting shops that had already projected four quarter-percentage-point increases in the Fed’s benchmark short-term interest rate this year.

Nomura sees the Fed raising rates four times this year and twice next year, adding one more additional rate rise to its forecast in both years. UBS also added one rate increase to its forecast each year, now expecting the Fed to raise rates four times this year and three next year.

Economists at Goldman Sachs Group Inc. and JPMorgan Chase & Co., which were among those already projecting four rate rises this year, have said the government spending package makes them more confident in those calls.

Markets have largely priced in at least three rate increases this year, and futures trading tracked by CME Group shows investors have placed a 23% probability on a fourth rate increase.

The Fed’s rate-setting decisions matter keenly to markets because of the likely impact on the values of bonds, stocks, currencies, real estate and other assets. The policies often, though not always, influence borrowing costs for households and businesses, such as through rates on credit cards, mortgages and corporate loans.

The Fed has raised rates five times since December 2015, most recently last December to a range between 1.25% and 1.5%.

At their December meeting, officials penciled in three rate increases for this year and two for 2019. Officials will unveil their updated projections after their March 20-21 meeting, the first since Congress completed the spending plan.

The Fed’s median projection for short-term rate increases in 2018 appears unlikely to change at that meeting, as it would likely require at least four out of five officials who have been projecting three rate increases to raise their estimates.

Economists aren’t entirely sure how the tax cut will boost growth. If household and business spending raises demand but not the size of the workforce or labor productivity, the Fed might conclude inflation will rise too far above its 2% target.

If it looks like the tax cut is likely to generate more investment and hiring — raising the economy’s capacity to produce goods and services — the Fed can tolerate faster growth without accelerating rate increases.

Many economists believe the spending bill will mostly boost demand for goods and services rather than increase supply, pushing unemployment down from an already low level. That would likely prompt Fed officials to raise rates a little more than they otherwise would, the economists say.

Economists at JPMorgan and UBS now see the unemployment rate falling to 3.2% at the end of next year, which would be the lowest level since 1953.

“I see a real challenge for the Fed, not because they’re not capable, but this fiscal stimulus coming now made a hard job even harder,” said Seth Carpenter, chief U.S. economist at UBS and a former Fed and Treasury official.

Even if the tax cuts end up boosting the economy’s output, “this may take some time before it shows,” said Michael Feroli, JPMorgan’s chief U.S. economist, in a research note earlier this month. “In the meantime, the Fed doesn’t have the luxury to wait” if investors expect inflation to rise.

Some private economists still forecast just three Fed rate increases this year.

If the Fed moves three times by its September meeting, its benchmark rate will be positive after adjusting for inflation for the first time in more than a decade, prompting the central bank to pause quarterly rate rises and see how the economy is responding, said Ellen Zentner, chief U.S. economist at Morgan Stanley, in a client note Tuesday.

Stronger growth over the coming two years could reduce the risk of a recession in those years, but it could also raise the risk of one in 2020, when the boost from the spending program fades and growth slows.

Another risk: The boost in debt-issuance by the U.S. Treasury resulting from higher budget deficits could lead to higher yields on government securities, driving up interest rates set by markets, choking the economy.

“We do not forecast a recession as our base case, but we believe the risk is material and rising,” said Mr. Carpenter.
Source: Dow Jones