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The Fed wants to raise rates this year. One thing could stand in the way

  • Much of Wall Street believes the Fed will rate interest rates twice more this year.
  • Lower-than-expected inflation might stop the Fed in its tracks, a possibility being priced into the futures and bond markets.
  • Economist David Rosenberg warns that the Fed could be risking recession.

As the Fed sets forth a fairly aggressive path toward higher interest rates, one key element could scuttle those plans.

Substantially lower-than-expected inflation would be a significant hurdle for the central bank in its quest to normalize a benchmark rate kept near zero through much of the post-financial crisis economy. The Fed has hiked the rate three times since December 2015 and economists and Wall Street strategists widely expect at least two more moves before the end of 2017.

However, the inflation numbers of late have not been cooperating.

The Fed's preferred measure, the personal consumption expenditures index, is showing gains of just 1.8 percent currently, excluding food and energy, and expected to fall even further. The consumer price index, which is a secondary measure in Fed officials' eyes, most recently showed a 1.9 percent gain for core and 2.2 percent on the headline.

As things stand now, Fed officials are writing off the recent soft economic numbers as "transitory," a go-to term for fluctuations that don't meet their economic expectations. Many experts on Wall Street thus expect the Fed to follow through with projections to hike interest rates twice more this year and begin the long process of unwinding its $4.5 trillion portfolio of government debt known as the "balance sheet."

Investors will get a closer look at behind-the-scenes discussion when the Federal Open Market Committee on Wednesday releases the minutes from its meeting earlier this month.

"We continue to expect the Fed to hike in June and September and announce balance sheet reduction in December," Citigroup economist Andrew Hollenhorst said in a note. "The drama at the June meeting may not be whether the Fed raises rates but what changes in the Fed official economic projections."

Federal Reserve Board Chair Janet Yellen holds a news conference after the central bank announced an increase in the benchmark interest rate following a Federal Open Market Committee meeting December 14, 2016 in Washington, DC.
Getty Images
Federal Reserve Board Chair Janet Yellen holds a news conference after the central bank announced an increase in the benchmark interest rate following a Federal Open Market Committee meeting December 14, 2016 in Washington, DC.

Hollenhorst believes those calculations will have to include a reduction in the PCE rate to as low as 1.4 percent, a pretty good distance from the Fed's 2 percent inflation target.

The question is whether that will have a material impact on policy.

Traders in the fed funds futures market who try to game where the benchmark interest rate will land do not believe the Fed will be as aggressive as Wall Street thinks.

Current indications are for a near certainty — an 83 percent chance as of Wednesday morning — that the Fed will approve a quarter-point rate increase in June. However, from there traders differ sharply from the Street consensus. The market is pricing in barely a 50 percent chance of another hike by the end of the year, according to the CME's FedWatch tool. Also, the futures market sees the Fed rate at 2.26 percent by the end of 2019, compared with the Fed's projection of 3 percent.

The bond market is also reflecting a more cautious tone than the Fed regarding growth, with the benchmark 10-year Treasury note at just 2.27 percent in Wednesday trading. The rate is considered a proxy for GDP plus inflation and is thus indicating a slow growth pattern ahead.

David Rosenberg, chief economist and strategist at Gluskin Sheff, believes the bond market, particularly the compression in yields between shorter-dated and longer-duration government debt, is troubling and not pointing toward an aggressive Fed.

"Long-dated yields have refused to move higher even as the Fed signals an intent to unwind its bloated balance sheet later this year," Rosenberg said in his morning note Tuesday. "With the Fed continuing to push the funds rate higher, this means a flatter yield curve with the risk of it inverting — take note because this has presaged every recession over the past 50 years."

As for Fed officials themselves, the rhetoric has tilted toward continuing down the path of steady rate hikes and balance sheet reduction. However, the market has been down this path before — in 2016 projections early in the year called for four rate hikes, but just one was enacted by year's end.

"The bond market is in synch with the Fed in the near term (a June hike is largely priced in) but pay attention to this divergence further out — it can't be sustained," Rosenberg said. "Just remember that 10 of the last 13 Fed hiking cycles have been miscalculations that ended in recession."