Based on Fed fund futures, the market consensus is that the Federal Reserve will hike rates three times this year by 0.25 percent each time.
But I personally believe that the market may have underestimated the pace of the rate hikes.
I think the Fed might raise the interest rate by up to 1 percent or even more this year for three main reasons.
First, the economy is overheating. The US economy – the global economy as a whole – has moved into another expansion cycle since the middle of 2016.
The strong growth momentum has yet to show any sign of moderating, and this is reflected in the earnings growth of constituent stocks of major US stock indices. US President Donald Trump’s sweeping tax cuts may further fuel economic growth.
Second, inflation uptick. The latest data shows that US consumer prices have risen 2.1 percent year-on-year, while the core inflation indicator followed by the Fed only edged up by 1.5 percent.
However, it remains unclear whether the inflation picture will continue to be benign given that the economic expansion has extended into the second straight year.
In fact, the US nominal GDP growth has a correlation co-efficient of 0.78 percent with the core inflation index, with a time lag of 18 months.
The US nominal GDP growth has bottomed out since the second quarter of 2016. That means we can expect more marked inflation from now on.
Moreover, global commodity prices have recovered considerably along with improving economic growth. That would also drive up inflation and prompt the Fed to accelerate the pace of rate hikes.
Third, the wealth effect from the stock market boom.
The US stock market has been on fire in recent years thanks to improving corporate earnings and weaker US dollar.
The Dow Jones Industrial Average, S&P 500 and Nasdaq have jumped 56.9 percent, 44.3 percent and 51.9 percent respectively since the rate hike on Dec. 17, 2015. The three major indices rose over 5 percent in January this year.
Rising asset prices will translate into economic overshooting via wealth effect, which in turn will push up inflation. In fact, the S&P 500 typically moves in tandem with the US GDP figure.
If the stock market continues to rally, the US may face a serious risk of economic overheating.
In that case, Fed may turn more hawkish and speed up the rate hikes to avoid such a risk. Therefore, we can expect at least four rate hikes this year, which will raise the rate by 1 percent or more.
This article appeared in the Hong Kong Economic Journal on Feb 1
Translation by Julie Zhu
[Chinese version 中文版]
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