There is a large gap between what the Federal Reserve (Fed) suggests it is likely to do and what the market believes the Fed will accomplish. The Fed's "dot plot," a survey of Federal Open Market Committee (FOMC) members' expectations for future policy, suggests that the Fed will likely hike interest rates twice more in 2018, three times in 2019 and two times in 2020. That's seven more rate hikes before the Fed calls it quits.

Market participants belong to a different school of thought. While the forward curve agrees with the Fed that a September 2018 rate is likely, as of Aug. 28, a December 2018 rate hike was priced with a more than two-thirds probability, according to CME Group's Fed Watch tool. For 2019, the market prices one or two, rather than three, rate hikes and it does not price any further rises in 2020. Basically, the market view is about half of what the Fed's dot plot suggests: three or four more 25 basis points (bps) rate hikes rather than seven.

Going forward, the challenge for the Fed is three fold:

1) Determining what is neutral policy

2) Not moving past neutral policy and overtightening

3) Remembering lag time between monetary policy changes and the impact on the economy

What is Neutral Policy?

Part of the challenge in not raising rates too much is figuring out what neutral policy is. There seem to be three broad definitions based upon the dot plot, inflation and the yield curve. The closest that the Fed comes to telling us what it thinks neutral policy might be is once again in the Fed's dot plot.

Currently, FOMC members estimate that the longer term equilibrium for the Fed funds rates to be 2.875 percent. That's close to the current level of yields (as of mid-August 2018) of both 10-year and 30-year U.S. Treasury yields. This suggests that unless there is a selloff at the long-end of the curve, that the "neutral" level for the fed funds rate would bring the yield curve to flat. This is surprising given that flat yield curves often occur ahead of economic slowdowns and recessions.

Not on Board. Investors Don't Buy Fed's Seven More Hikes in Two Years.

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Go on Hold in 2019?

Our base-case scenario is that the Fed is very close to going into a holding pattern. The argument that the Fed might raise rates twice more and then go on hold rests on several assumptions. First, the Fed appears aware of the rise in both public and private debt to record levels. Rising rates increase the cost of servicing debt and raise the risks of recession. Second, and related, the yield curve has flattened considerably over the past 12 months. By our analysis the yield curve already indicates that the Fed has achieved a "neutral" interest rate policy, meaning more tightening. That might completely flatten or even invert the yield curve and could be the trigger for a 2020 recession.

Third, so far, the U.S.-driven trade war is not impacting the U.S. economy very much, but global growth does appear to be slowing and many emerging markets are feeling the pressure. A global slowdown would decelerate U.S. growth, even if it does not cause a recession. Our analysis disagrees with the futures market consensus, as we put a 60 percent probability on just two more rate rises before the Fed goes on hold.

Looking to 2020

The current U.S. economic expansion will soon be the longest on record. We do not think economic expansions end because of old age. It takes a domestic policy mistake or a serious external disruption. With rapidly rising debt loads, a nearly flat yield curve, escalating trade wars and disruptions in emerging market currencies and economies, there is no shortage of factors which might serve as a catalyst for ending the current expansion. By our analysis, the probability of a recession in 2020 appears to have risen to 33 percent.

Written by Blu Putnam and Erik Norland. Read more from the authors here.

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