Rate Normalization to Continue Above 2 Percent

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The following is a summary of our recent interview with Gargi Chaudhuri, which can be accessed on our site here or on iTunes here.

We’ve heard talk about Fed rate hikes being range bound recently, with several analysts on FS Insider suggesting that the Fed doesn’t have much room to tighten beyond 2 percent.

This time on the show we spoke with Gargi Chaudhuri, macro strategist at BlackRock, about where we are in this rate hike cycle, and what she expects going forward.

Rate Normalization in Progress

Chaudhuri wants to move away from the idea that this recovery is going to die of old age. The fact is that the Fed funds rate going to zero was extraordinary — that it represented an emergency level — and it suggests there is more room to raise rates this cycle than some have suggested.

Since we hit zero, we’ve had a magnificent recovery in the economy, Chaudhuri noted. The unemployment rate is back down at 4.7 percent, wages are growing, and inflation, the one area of the Fed’s mandate where we weren’t seeing the level that we wanted, is finally starting to trend higher.

“We believe that what the Fed is doing now is moving away from these emergency levels to more accommodative levels in policy,” Chaudhuri said.

With rates right now at 1 percent, she pointed out, and inflation running at 2 percent, the real rate of growth in the economy, or the real rate of funds in the economy, is still at approximately negative 100 basis points.

At that level, the economy is still very robust, and the Fed Funds rate is very accommodative, she noted.

“At this stage, we’re really not concerned that any move from the Fed will stop any growth trajectory going forward,” Chaudhuri said. “We happen to think that as the Fed moves to normalize rate policies, that’s actually good for the system.”

This leaves financial systems open to be more efficient as we develop net interest margins that have been in decline for a long time, she added. As that comes back into the system, we’ll likely see moderately high velocity coming back as well, and along with it, growth.

How Will Households Benefit?

We need to give the current rate hike cycle some time for households to see the benefit of the increases. This rate rise cycle has been very deliberate and the process has just started, Chaudhuri noted.

“There is a deposit in excess of $11 trillion (in household deposits and money market funds),” she said. “As rates continue to move higher, if we see another 1 percent increase in rates, that actually equates to over $110 billion of income, which is basically $1,000 extra per household.”

This doesn’t take into account other fiscal possibilities, such as tax cuts in the future, and it alone will lead to a better consumption outlook and increased leverage, which she expects to shift back up.

This is all a consequence of the extreme nature of rates staying at zero for so long, and the belief that has developed that rates are going to be low forever, Chaudhuri stated.

“We just need to see the rate normalization continue for Fed Funds to get to a more palatable level, which will then bring back the deposits and savings,” she said.

Have Bonds Peaked?

While no one has a crystal ball, based on what we see in terms of growth dynamics and inflation dynamics, Chaudhuri thinks it’s safe to say the Fed is going to continue on this path of rate normalization.
She expect the Fed to raise two more times this year, for a total of three hikes for 2017, and to continue on that path in 2018 and 2019 as well.

“I think barring some major exogenous shock to the system, it’s safe to say …  we’re not going back to the137-type yield on the 10-year note that we saw back 2 years ago,” she said.

It’s important to avoid going to extremes here, though. While she expects rates to rise from here, it’s going to be quite modest, she said, with the Fed behaving deliberately. She doesn’t see us hitting 4 or 5 percent yields, for example.

“Given the demand/supply imbalance, given that we think there’s so much cash that’s sitting on the sidelines, as soon as rates go up a reasonable amount — call it 50 to 100 basis points higher — we think that cash is put back into work, which keeps (a lid on) rates in the US” she said. “Our view is that (we’ll see) higher rates, but very much in the 2.7 to 3.25 range.”

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