The end is in sight for Zero US rates

US inflation is rebounding. Both goods and services prices increased in April, pushing the CPI up to 2% YoY after nearly a year below the Federal Reserve’s target. Pressure is coming from housing rents and, lately, from the rebound in commodities. Businesses are also raising prices as wage growth squeezes margins, and better off consumers prove willing to pay more. This could be viewed as just the rebound in real activity and inflation that the Fed has strived for. On its own, it would be good news for corporate earnings and equity markets. But the flip-side is that it casts doubt over the future of the Fed’s zero interest rate policy. For the last year, markets have had it easy. Price rises have been well below the Fed’s 2% target and inflation expectations soft. As the Fed began to taper its asset purchases, weak inflation meant that it could afford to keep its policy pedal pressed firmly to the floor, with interest rates at zero. Those times have passed. With inflation back on target, the Fed is busy discussing its exit strategy, as the minutes of April’s meeting show. New York Fed president William Dudley recently made it clear that the Fed is inclined to begin raising short rates without starting to shrink its balance sheet. That the bond market may not have to digest a sell-off in the Fed’s assets should be welcome news, but the markets are focused more on Dudley’s juxtaposition of the word “rate” with the word “hikes”. The fear is that rate rises could trigger a bear market in equities or even an economic recession.

Eventually, tightening will indeed cause a bear market and a recession. It always does. Easy policy ushers in a boom, tighter policy causes a bust. That’s how the system works. The important questions are about timing: 1) When will the Fed start to hike interest rates? And, 2) How long will it be before higher rates start to restrict growth?

To answer the first question: some at the Fed are sounding rather hawkish. Emboldened perhaps by the recent rise in inflation measures, St. Louis Fed president James Bullard said last week that short rates could rise as early as the first quarter of 2015 (the consensus is for later in the year). The basis for his view is a belief that the labour market is tightening faster than most realise; an argument we endorse. Philadelphia Fed president Charles Plosser has made similarly hawkish comments.

But the view that really matters is Fed Chair Janet Yellen’s. As far as we know, she still thinks the first rate hikes are likely in the second half of next year. And while some may think the labour market is mending fast, note that Yellen has done away with a simple unemployment rate threshold in favour of a half dozen measures. That means she can probably find at least one indicator to justify any rate she wants.

In her defence, the growth outlook remains uncertain. So, Yellen is unlikely to raise short rates quickly unless inflation expectations come un-anchored. The bond market shows no sign of that yet.