When the Fed started raising its policy rate last December, it also announced plans for 1% of further rate hikes in 2016. However, since then the economic situation in the US has deteriorated, forcing the Fed to scale back those plans. In recent weeks positive signals about the US economy have begun to pop up again. These could pave the way for an upward surprise from the Fed later in the year.
The rapid deterioration of the economic climate in US manufacturing throughout 2015 was a serious concern for the overall outlook for the US economy. As manufacturing is more often than not a leading indicator for the rest of the economy, the troubles in the sector could easily indicate a path to a new recession. However, the early regional confidence indicators for March (in New York and Philadelphia) show a substantial improvement. If this is confirmed on a wider scale, concerns about the health of the US economy can be significantly eased.
On top of that, there are signs that inflation is starting to pick up. US core inflation has increased from 1.6% at the end of 2014 to 2.3% today. While there is no reason to start worrying about inflation getting out of hand, the uptrend in core inflation does highlight that the Fed cannot put off raising interest rates indefinitively.
Against that backdrop, financial markets remain very relaxed about the Fed’s rate hiking cycle. While the Fed now plans two rate hikes this year, markets expect only one. Moreover, markets also expect only one further hike in 2017 and one in 2018. Markets expect the Fed’s policy rate to be just above 1% at the end of 2018, while the Fed aims to be at 3% by then. This discrepancy has to correct at some point. Up to now, the corrections have mostly been on the side of the Fed’s plans. The combination of improving signs about the economy and rising core inflation is likely to lead to a correction on the side of market expectations. If not, markets are heading for an upward surprise from the Fed later in the year.