PIMCO held its quarterly Cyclical Forum last week, and it won’t surprise anyone that we spent a lot of time talking about the Federal Reserve. We concluded that, barring a “zombie apocalypse” (as one of our participants colorfully phrased it), the Fed on 16 December would commence its first rate hike cycle since the previous cycle that began in June 2004 under Alan Greenspan and concluded in June 2006 under then Fed Chairman – and now PIMCO Senior Advisor – Ben Bernanke (who attended and participated actively in the forum).
A lot has happened in those 11 years, and indeed a lot has happened since we last met in September 2015. At the September forum, we were focused on assessing the hard landing risk for China as well as the possibility that the Fed under Chair Janet Yellen might choose not to hike at all in 2015, or perhaps ever. Since then, concerns over China have receded somewhat – although by no means have they disappeared – and robust U.S. payrolls data and some evidence that wage inflation is increasing have given the Fed the hard data it needs to commence a rate hike cycle.
The market as of today prices in a roughly 75% chance the Fed will hike on Wednesday, so a Fed hike in and of itself is largely discounted. Wednesday’s announcement and the press conference and Summary of Economic Projections (including the dot plot) to follow will be important nonetheless because they will give the Fed a chance to shape market expectations about the pace of and destination for the rate hike cycle to follow. And we do believe it will be a rate hike cycle – the chances of a “one and done” single-hike scenario are about equal to those of a zombie apocalypse!
That said, we take Chair Yellen at her word that in this New Neutral world – and yes, even the Fed has embraced the new “neutral” real interest rate and now uses that term – the Fed’s liftoff trajectory is likely to be the most gradual on record. Crucially, even with the labor market at the Fed’s definition of full employment and with inflation expected to rise to 1.8% by year-end 2016, the Fed will signal that it expects liftoff to be gradual not because it aims to be behind the curve, but rather because the neutral policy rate itself is depressed and is expected to rise only very gradually over time.
The Fed’s hope will be that, by justifying the liftoff plans in this way, it can engineer a “dovish” hike that limits any ensuing rise in bond yields or sell-off in equity and credit markets. While that is the Fed’s plan, investors will need to stay tuned to monitor and assess how well it can execute that plan in the months – and years – ahead.