Among possible candidates as the next head of the Federal Reserve, President Donald Trump has reportedly talked with Kevin Warsh, a former Fed governor. Warsh, who shares Trump’s views on reducing regulation, is considered a hawk.
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In January he asked “why interest rates seem to be so far away” from their long-term target, when the Fed is close to achieving its goals of maximum employment and price stability.
But while a Warsh nomination would be viewed as taking the Fed in a more hawkish direction, we believe that even with the current composition of the Federal Open Market Committee, the market is underestimating the likely trajectory of interest rates:
- Yellen has strongly hinted at another rate hike this year, saying it would be imprudent to keep monetary policy on hold until inflation is back to 2%.
- The Fed has prepared the market for the next step in withdrawing monetary accommodation, announcing that it will start shrinking its balance sheet this month.
- Macroeconomic data support the need for further tightening. The ISM manufacturing index reached a 13-year high in September and unemployment is close to 16-year lows.
So while market expectations have started to adjust, with the probability of a December rate hike based on Federal Funds futures having increased to 70% now from 22% on September 8, longer-term market underpricing remains. We expect two rate hikes in both 2018 and 2019, and two-year US Treasury yields to rise to 1.8% in six months compared with 1.47% currently.
Read Are markets prepared for a hawkish Fed chair? published October 5, 2017.