Markets remain obsessed with relatively minor changes in US official interest rates expectations. The FOMC revealed that at least three interest rate increases next year look reasonable, slightly higher than prior forecasts of two. No one should be surprised. Given the starting point levels of interest rates, the relative insensitivity of spending to the fed funds rate, and the pro-cyclical policy intentions of the new US administration, rates may well rise by considerably more than the FOMC currently expects.
Markets had already anticipated the rise and adjusted accordingly, and as a result the immediate market reaction has been logical, albeit relatively trivial in the context of post-Trump volatility. The dollar has rallied, the yield curve has flattened and the equity of the large US money centre banks, which profit most from rising Fed funds, are out-performing a weak stock market.
Interest rate markets remain complacent about the scope for US interest rates to rise over the next two years. The chart below shows the effective fed funds rate implied by futures market. This would suggest that by December next year the market anticipates rates to be at 1.3%, and that the anticipated change in rates in 2017 is not that different from what was expected in the middle of the year.
The Fed should welcome the new administration’s pro-cyclical policy intentions. A dose of Trumpian animal spirits may be precisely what is required to shift the steady growth of the US economy up a notch or two, allowing the Fed to get rates up significantly away from zero and closer to 3-4%.
It is worth remembering that in the same way that ever lower rates at a certain point proved counter-productive, a rise in interest rates may prove less of a constraint (or even a positive, as “Neo-Fisherism” would assert). Banks may well ease lending conditions in response to higher margins, and if corporate optimism feeds through to a tighter labour market and wage increases, final demand may prove as immune to higher interest rates as it did to ever lower global policy rates in recent years.
This could further drive the differential economic dynamics of the US versus Europe, which have again been highlighted by the Fed’s move. While US two-year Notes are at the highest level for seven years, German two years are at all-time lows.