On Tuesday, we got the latest egregious example of regulatory capture with the appointment of Neel Kashkari to the Presidency of the Minneapolis branch of the Eccles cabal. Here’s what we said:
At a certain level, the staffing of government agencies, regulators, and other public sector bodies with former Wall Streeters and various bulge bracket bigwigs has become so ubiquitous that it’s hardly even news.
Still, it’s worth paying attention to the dynamic because losing track of who’s really running things is a bad idea if you want to understand why it always seems like regulatory outcomes are never commensurate with the crime and if you think monetary policy and all types of other high level decisions regarding the economy are conducted at the behest of those who are ultimately beholden to the bankers.
Note once again that all three new regional Fed Presidents appointed this year have at one time worked for Goldman and now, four of the five regional Fed presidents voting in 2017 will be Goldmanites.
So for those interested to know where rates are headed now that Janet Yellen has put herself and the rest of the FOMC in a position where they at least have to try to hike (and no, they probably don’t have anything left in terms of credibility at this point, but we suppose you still have to think that we’ll see some manner of effort to normalize otherwise, why even bother meeting), just ask Goldman, who’s out today with an explanation of why rates are likely to rise faster than the market thinks.
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From Goldman
The market discounts that the Fed Funds rate will be at around 85bp by December 2016, implying an additional two hikes in the next calendar year. More interestingly, the forwards discount that in 2017 the pace of rate hikes will slow to a cumulative 50-75bp, leaving policy rates just below 1.5% by December 2017.
Our US Economics team’s modal forecast calls for 100bp cumulative hikes during 2016 (Fed Funds would end the year at 1.4%) and a further 100bp tightening during 2017 (at the end of which Fed Funds would stand at 2.4%). The gap between our baseline projections and the forwards grows over time (around 40bp at end-2016, 80-90bp at end-2017, over 100bp by end-2018, as shown in Exhibit 1).
One of the main reasons why we see a higher trajectory for policy rates is that, with the economy expected to continue to expand faster than its 1.75% potential rate of growth, pressures on wages and core inflation (particularly in services components) will build, as illustrated in Exhibit 2. The market, however, does not appear to be pricing this.
Core CPI inflation is already trailing just below 2% at an annual rate, with the persistent price dynamics in service ex-energy category contributing 210bp to the readings. Yet, US inflation swaps price annual inflation rate at around 1.0% by December 2016, climbing to 1.6% in both December 2017 and 2018.
Based on the current forward curve for crude oil, this tells us that the market is either pricing that underlying core inflation will decelerate or that the distribution of risks around the inflation outlook is skewed to the downside. The inflation option market would support the latter interpretation: the market currently assigns around a 35% probability to a scenario in which US CPI inflation averages less than 1% over the next 5 years.
In both cases, the market prices that policy rates will at best hover close to zero in real terms over the coming three years. If we take our US Economics team’s projections for headline CPI over these same horizons, which are 60-80bp above the inflation forwards, and subtract them from the market-implied path for Fed Funds, real policy rates are set to be negative to the tune of 80-100bp by end-2017.
Given where the US economy is now and where we think it is heading, we find it hard to believe that real policy rates will be zero in two years’ time, let alone negative 1%.
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Basically, Goldman is expecting a hockeystick inflation miracle which will prompt the very “data dependent” Fed to hike 200 bps by the end of 2017 after having not hiked in a decade.
Of course Goldman would be correct that inflation is likely to remain far higher than the market “thinks”, because as long as rates are still low on a historic basis, and as long as the rest of the world is still engaged in all manner of ludicrous Keynesian experimentation with negative rates and equity monetization the world’s ultra rich will continue to buy their $100 million real estate and their Modiglianis, inflating asset bubbles of epic proportions. But when the Fed and other DM central planners look at inflation, they tend to purposefully leave out all signs out it and then use the lowballed figure to explain why still more easing is necessary.
So who knows, especially now that the new reaction function explicity includes financial markets both foreign and domestic which means that it’s no longer clear to investors what they should be pulling for: a hike which telegraphs a positive assessment of the economy but tighter policy, or a hold, which telegraphs a less sanguine assessment but portends more ZIRP. In short, no one has any idea whether bad news is bad news or bad news is good news or good news is… You get the idea.
It’s enough to make you throw up your hands (or pull out your hair) but we suppose going forward (or at least beginning in 2017), we can just look at what Goldman thinks and assume that’s where the Fed is heading. Then again, that’s always been the case.
