Jerome Powell faces a difficult task in guiding markets through his first interest rate decision as Chairman of the U.S. Federal Reserve this week as the world's largest economy steams ahead under the power of deficit-inducing tax cuts and job growth while showing little signs of the faster inflation that normally follows.
Yet while Powell and his colleagues on the Fed's Open Markets Committee are fully expected to lift the central bank's key policy rate by 25 basis points, or 0.25%, to a range of 1.5% to 1.75% Wednesday in Washington, the key question will be they signal a willingness to lift rates three more times after that, given the underlying strength of the economy and the pace of growth in the labor market.
"By continuing to gradually raise interest rates over time, we're trying to balance (employment and inflation) and achieve inflation moving up to target but also make sure the economy doesn't overheat," Powell told lawmakers on the U.S. Senate Banking Committee earlier this month, before quickly adding that "there's no evidence the economy is currently overheating."
Global Govt Bond Yields rise ahead of FOMC announcement as 'dot plot' could be revised up from three hikes to four hikes in 2018 and a more hawkish path in 2019. pic.twitter.com/5f0gRogRLc— Holger Zschaepitz (@Schuldensuehner) March 21, 2018
The CME Group's FedWatch tool, however, suggests investors are split as to whether Powell can execute four hikes this year and take the Fed Funds rate to between 2.25% and 2.5% by the end of the year, with a 40% probability of rate topping out just below that mark and a 30% chance of a fourth rate hike before the end of the year.
That split is no surprise, given the mixed signals we're seeing in the U.S. economy, where 313,000 new jobs were created last month, the unemployment sits at a 17-year low of 4.1% and consumer confidence in running at a 14-year high.
However, retail sales have fallen for the third consecutive month in February and despite the robust jobs market, average hourly earnings are only growing at 2.6%, a pace that is only modestly faster than headline inflation, which is running at around 2.2%, according to the Labor Department's latest reading.
"Strong activity in the US economy is clear for everyone to see, but there are a broader range of views on inflation," said ING's chief international economist James Knightley, who is forecasting four hike this year. "We are on the more hawkish end, believing we could see headline CPI reach 3% this summer. Throw in rising wages and we think financial markets are a little too complacent about the path of inflation."
Powell's tone Wednesday, however, is likely to have far more implications the direction of U.S. stocks, which have stalled this month after recovering much of the February correction on the back of renewed concern that President Donald Trump's trade policies could spark retaliatory tariffs in Brussels, Tokyo and Beijing.
A clear suggestion that base rates will rise four times this year will quickly take 10-year Treasury yields past 3%, a move that could trigger the flow of funds from equity markets into fixed income portfolios that offer richer returns.
With S&P 500 stocks trading at a 12-month forward PE ratio of 17.1, according to FactSet data, well ahead of their 10-year average of 14.3, stocks are not only looking historically expensive, but they're also offering significantly limper returns than they were last year.
The SPDR S&P 500 ETF Trust (SPY) has given investors a total return of 1.79% so far this year on a price basis, and just a 1.82% return on a net asset value basis, according to Morningstar data, compared to the 2.32% risk-free yield to maturity currently priced into benchmark 2-year Treasury notes.
Powell's statement on Wednesday could make that arithmetic even more compelling.