US rates: Beyond neutral
Markets are embracing a faster pace of Federal Reserve (Fed) hikes, but we believe the unique US situation in housing and autos makes its economy even less sensitive to higher rates this year. Terminal rate expectations still appear too low, in our view.
The Fed’s hawkish pivot continued at the March Federal Open Market Committee (FOMC), with the dot-plot forecasts suggesting a further six hikes this year and rates edging above its estimate of neutral by the end of 2023.
Just in case this message did not land as intended, subsequent speeches from the Fed (including by Chair Powell) appear to be setting up markets for a 50 basis point hike at the May meeting.
We had previously discussed why the US economy was not likely to be as sensitive to rate hikes as the market appeared to fear, largely because the private sector had reduced its debt and households had locked in low long-term mortgage rates.
We can now add to this list. First, we see the economy overheating to an even greater extent than we envisaged; we have yet again revised up not only the near-term path for inflation but also through 2023 as well. With nominal variables growing at a faster pace, it should take higher rates to deliver the same real interest-rate effect. As inflation is further above target, arguably real interest rates also need to be even higher to force it back down. So, a double whammy on rates.
Second, monetary-policy tightening acts by squeezing demand in the most interest-rate-sensitive parts of the economy. These have traditionally been housing and autos. But both sectors are currently in a unique situation, which means rate hikes this year are unlikely to slow demand.
The housing market is booming, with ongoing double-digit price rises. The pandemic has constrained supply while at the same time boosting demand. There is a chronic shortage of homes for sale, and plunging vacancies are putting significant upward pressure on rents. Homebuilding has been slow to respond and has suffered from supply disruptions and worker shortages. So even as rates rise, homebuilding is likely to continue increasing to meet demand and replenish inventories.
The auto sector also appears in an extreme imbalance. Inventories have virtually disappeared, sales have been constrained by lack of supply, and prices have rocketed. Even as interest rates rise, providing some of the supply disruptions eventually ease, production should increase to meet pent-up demand for autos.
So these sectors are unlikely to drag on growth as macro models would suggest, for at least the first year of the tightening cycle, and could force the Fed to go even further. Indeed, FOMC participants are increasingly talking about the potential for the Fed to go into restrictive territory to restore price stability.
While the market is getting aggressive for the near term, even the latest implied path is probably not enough to get inflation ultimately back to target. Given the sharp move up in yields through the first quarter, though, it will likely take some time from here for this to become apparent – especially given the heightened macro uncertainty caused by the pandemic and war.