Capital Ideas^™ 
Investment insights from Capital Group

The Federal Reserve has raised rates in its December monetary policy meeting for the fifth time since 2015, increasing the federal funds rate to between 1.25% and 1.5%. This move was widely anticipated by the market, as the Fed has been communicating a lean in this direction for the last several months.

As we look to 2018, I think the Fed will continue to hike rates gradually, at the pace of roughly once each quarter, if the economy continues to run smoothly, inflation remains near its 2% target and equity markets don’t have a major downturn. Markets are currently pricing in two hikes for 2018. That seems like a reasonable expectation, looking at the bigger picture, as markets put a little under 50% probability that a negative event such as an equity market sell-off or an economic slowdown could slow down the Fed’s pace.

While this is our baseline Fed forecast, there is still a lot we will be watching. There are currently three vacancies on the Federal Reserve Board of Governors, including the vice chair seat. In addition, Bill Dudley will retire as president of the New York Fed next year, and his replacement has yet to be announced. While incoming Chair Jerome Powell represents a likely continuation of the status quo, all of the turnover does present the potential for some uncertainty. We will be closely watching for appointment announcements and appointee speeches to get a sense of how Fed policy might shift.

Assuming that new Fed members don’t instigate any major changes of direction, my outlook is informed by two key metrics that correspond to the Fed’s dual mandate: employment and inflation.

The labor market continues to tighten.

Broadly speaking, the Fed has been comfortable with the unemployment rate for some time. At 4.1% in November, it was at the lowest level in 17 years. Strong job growth has continued, suggesting that over the next few years, barring unexpected shocks or a downturn, the national unemployment rate is likely to head south of 4%, possibly hitting the lowest levels since the 1960s.

The missing link, however, is wages. Private sector wage growth in the third quarter was 2.6%. While this is an improvement over what was seen in preceding years, that growth rate remains well below what one would expect to see with unemployment rates this low. This could be due to a few factors, such as the Great Financial Crisis leading to an unusually severe skills mismatch among job openings and job seekers, or the need to consider a measure of labor market slack that takes factors like discouraged workers into account. As a result, even lower unemployment rates may be needed to see wage growth reach or exceed 3%.

That said, our forecast is for wages to pick up because we think that at this level of unemployment, the relationship between wages and employment slack should get stronger.

Inflation not likely to hold back hikes in 2018.

Wages are a significant factor in inflation, and their tepid growth helps to explain why, despite the U.S. economy’s solid trajectory, inflation has recently run below the Fed’s target. Year to date, inflation measured by the core Consumer Price Index (CPI), which excludes often volatile food and energy prices, is running at 1.6%. That’s on the low side but not too far from the Fed’s target.

However, modest wage growth wasn’t the only factor holding back inflation in 2017. There was a five-month stretch from March to July when annualized core inflation was running at only 0.6%. A handful of seemingly temporary factors explain this pocket of weakness.

Wireless telephone service: The biggest culprit was wireless telephone service. Major cell phone companies offered unlimited data plans without changing the overall cost. This resulted in a quality adjustment that took the imputed inflation lower. However, my view is that while wireless pricing changes may remain low or even slightly negative, it will be nowhere close to the large negative numbers seen earlier this year (-7.0% in March and -1.7% in April).

Apparel: Apparel inflation was also unusually low. During that five-month weak patch, apparel printed at a -4.0% annualized rate. This compares to 0.0% apparel inflation in all of 2016. Apparel should firm because the dollar strength seen from 2014 to 2016 actually reversed in 2017. This should be a positive for both apparel and home furnishings prices. The late 2014/early 2015 dollar strength resulted in very weak apparel prices, and I expect the relationship to hold on the reversal.

Other temporary factors: Other pockets of weakness included used cars and trucks, airfares and lodging away from home. Prices of these groups have already stabilized or reversed. With the economy growing at a moderate pace, I believe that should continue to be the case. 

TIPS outlook

When we look at inflation so far in 2017, excluding the weak patch, core inflation printed at a 2.5% rate.  This rate is roughly in line with my expectations for a 2.3% to 2.7% core inflation rate in 2018. After backing out our assumptions for food and energy prices, we estimate that the market is pricing core inflation to be about a 1.8% next year.

This makes me bullish on the Treasury Inflation-Protected Security (TIPS) asset class for 2018 as I think higher realized inflation than the market expects will result in an increased demand for TIPS. I also believe TIPS provide a good risk/reward asymmetry.

With the unemployment rate at 4.1%, we believe core inflation is likely to stay firm or rise from here as capacity in the labor market continues to diminish. On the flip side, city-level data shows that it is quite possible for inflation to accelerate to 3% or even higher if the labor market remains strong. These factors, paired with the potential tax cut stimulus coming from Washington, should keep the Fed on its rate-hiking path – unless an unforeseen shock throws it off course.

While I expect the Fed to continue raising rates in 2018, I do not expect long-term rates to rise meaningfully. I expect the 10-year Treasury, which is often the benchmark rate for mortgage loans, to remain range bound between 2.25% and 3%. Given tight valuations for credit, corporate bonds remain vulnerable to a widening of spreads to Treasuries. Against this backdrop, investors who take a broadly diversified approach in their fixed income allocation and avoid excessive credit risk shouldn’t feel a dramatic impact from Fed policy.