Uncertainty shrouds future rate hikes and inflation growth

The Bank of Canada’s “neutral zone” is at 2.5%, the Fed’s at 3%, but reaching these neutral zones might prove more mirage than reality

Yan Barcelo 20 December, 2018 | 6:00PM

Should investors ready themselves for a “new normal” of increasing interest rates, declining stock performance and improved bond yields?

This is in line with expectations that both the U.S. Federal Reserve and the Bank of Canada (BoC) are set to increase rates through 2019. But it is far from certain that those expectations will play out.

Yesterday, the U.S. Federal reserve hiked its benchmark interest rate by a quarter of a percent, to 2.5% from 2.25%. It projects two rate hikes in 2019.

Over the past two years, the Fed and the BoC have taken advantage of more vigorous vital signs in the economy to crank up interest rates. Their hope is to attain at least a “neutral level” for rates, where rates neither stimulate nor dampen economic growth.

The BoC sets the entry point of that neutral zone at 2.5%, the Fed, at 3%. Presently, the overnight rates for both banks are 1.75% and 2.25, indicates Paul Borean, senior fixed income analyst at Signature Global Management.

According to many observers, reaching these neutral zones might prove more mirage than reality.

Until now, economic growth made central banks’ job relatively easy. In Canada, yearly growth in 2017 reached the 3% mark, points out Pedro Antunes, chief economist at the Conference Board of Canada. In the U.S., a similar rate of growth is expected for the whole of 2018, says Kevin L. Kliesen, business economist and research officer at the Federal Reserve Bank of St. Louis.

Those are very encouraging numbers that have propelled an unemployment rate in the U.S. of below 4%, and higher wage demands. Kliesen points to “an increase in the employment cost index from 1.8% in early 2016 to 2.9% in the second quarter of 2018 – a 10-year high”.

All that should prompt inflation to pick up. And an increase in inflation would be the next stepping stone on which central banks could base their decision to pursue rate increases.

But inflation is not picking up, and stubbornly remains below the 2% yearly rate increase the Fed and the BoC target. True, the rate in the U.S. presently hovers just under the 2% mark, but the 3-month annualized rate is on a sinking trajectory to 1.1%, indicates Krishen Rangasamy, senior economist at the National Bank of Canada. That is a zone it has repeatedly visited since 2011.

Kliesen’s models point in the same direction. “We see inflation slowing down over the next 12 months to 1.5%.”

Many reasons explain inflation’s steady hold below 2%. First, the central banks have acquired a lot of credibility in keeping inflation under control and “that control has disciplined economic actors into staying within target and keeping a rein on salary increases; they know that inflation has to stay within the 2% zone, otherwise central banks will intervene,” explains Benoìt Durocher, executive vice-president and chief economist at Addenda Capital.

Other factors are also at play to hold inflation in check. Corporate profits are outpacing wage increases and allow companies to cushion the blow of rising costs. In the third quarter, “corporate profits rose to a record US$2.3 trillion (...) which is more than double the 4.2% increase for wages and salaries”, writes Rangasamy. Also, “technology is disrupting different areas and inhibiting retailers from passing higher prices – linked to higher trade tariffs, for example – on to consumers,” adds Borean.

To top it all off, economic growth is slowing. “We expect growth to slow down not only in Canada and the U.S., but also worldwide,” says Antunes. In Canada, the main concern for the BoC is the price of oil, and Alberta’s three-month halt in production, Antunes points out.

“That puts a lot of doubt and raises a lot of question marks concerning the BoC’s outlook for a neutral rate at 2.5%,” claims Geoff Marshall, senior vice-president and portfolio manager at Signature Global Management.

For Antunes, the suspension in oil production is bad enough, but what is even more worrying – though the BoC makes no mention of it – is the depressed level of private investment, which has sunk from $76 billion in 2014 to $66.5 billion in 2016. Though it picked up at a yearly level of $74 billion in the first half of 2018, it dipped by 10% again in the third quarter.

“All that means that the pressures we’ve witnessed (and that were prompting the BoC’s rate increases) will be dampened from now on,” says Antunes.

Clouds are also hanging over the U.S. and world economies. Though the U.S./China trade dispute has paused, it still lingers and could flare up. Corporate indebtedness is extremely high not only in the U.S., but also worldwide. “We’re not only talking about debts of U.S. corporations”, says Rangasamy, “but of debts held in US dollars by corporations worldwide. The total is US$11 trillion, an astronomical level that we’ve never seen.” Furthermore, many of those debts carry a –BBB rating, lower than investment grade quality. Much of that results from the race for yield prompted by the easy monetary conditions set in by central banks all over the world since 2008.

If economic conditions worsen, many corporations could lack the revenues and profits to meet their obligations and that could trigger a debt deflation cycle, along the lines of what we witnessed in 2008. Though he recognizes the possibility of such an event, Kliesen sees little chance that it will materialize. However, Rangasamy thinks chances are substantial.

Furthermore, the U.S. economy could lack the boost of US$4 trillion that Donald Trump promised would be repatriated following the 2017 Republican Tax Bill. To this day, according to a recent Morgan Stanley report, only US$514 billion has come back, and the flow of repatriation is slowing. While US$300 billion came back in the first quarter of 2018, only US$100 billion will find its way home in the third quarter, according to Morgan Stanley.

The worry now is not about rising inflation and inflation rates, but about slowing – even darkening – economic conditions, notes Rangasamy. And that will cause central banks to pause their rate increases. Chances are that the Fed will proceed with a rate hike on December 19, but the next two projected hikes could remain on hold.

Since 2008, “the new normal was ‘lower for longer’,” states Geof Marshall, referring to the prolonged regime of extremely low rates that set in following the financial crisis. That “new normal” is what we should expect for a while more, he adds. “It’s hard to justify sustained higher rates from here on, unless we see inflation pick up, something we have simply not seen to this point.”

So, “retirees should not be hoping for a lot of upside on bond returns and yields,” states Marshall, while stocks could continue to do relatively well, but with significantly increased and persistent volatility.

About Author

Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience, writing for many publications in Toronto and in Montreal, including CPA MagazineLes Affaires and Commerce.