Quantifying The Impact of Upbeat Inflation Figures On The Fed’s Rate Hike Decision

The U.S. equity market has seen considerable volatility over recent weeks, partly because expectations of a steady increase in inflation have prompted investors to sell off some equity market holdings and move some proceeds into the bond market. This behavior is sensible, as a high inflation rate coupled with the low unemployment rate is likely to prompt the Federal Reserve to accelerate its rate hike process.

But how might the Fed change its rate hike plan based on changes to inflation, unemployment rate or GDP growth? To answer this question, we created an interactive model that quantifies the impact of changes in the U.S. GDP, unemployment rate and inflation rate on the benchmark interest rate.

Understanding Why These Metrics Matter To The Fed And Investors

Since late 2014, the Federal Reserve has largely based its decision to change benchmark interest rates on three core metrics: Changes in U.S. GDP, U.S. Unemployment Rate, and Inflation Rate (as measured by Personal Consumption Expenditures, or PCE). These three metrics have guided the Fed’s decisions to hike the benchmark rate by 25 basis points (0.25%) on five occasions since December 2015, to help it reach the current levels of 1.25-1.50% from the lows of 0-0.25% maintained over 2008-15.

In late 2016, the Fed detailed its plan to hike rates three times annually between 2017 to 2019 as long as these three metrics remain around the projected long-term targets. However, changes in one or more of these metrics could lead the Fed to slow down or speed up its rate hike plan. Notably, the current environment favors a faster rate hike – something that could potentially have a negative impact on near-term growth rates across many industries. This, in turn, could help to explain the string of equity market sell-offs over recent weeks.

Quantifying The Impact Of These Metrics

Our base case scenario represents the Fed’s current plan as detailed in its most recent FOMC Projections. Under the base case, the benchmark interest rate will increase to 3% by the end of 2019, and should remain around that level in the long run.

The Fed will stick to this plan provided the U.S. GDP growth rate remains close to its long-term target of 1.8%, unemployment remains around the natural long-term rate of 4.6% and inflation hovers around 2%. It should be noted that while an increase in GDP growth or inflation could speed up the Fed’s rate hike process, an increase in unemployment would likely slow down the process.

However, if any of these metrics stray too far from the Fed’s long-term target figure, it could attempt to bring them back on track by altering the pace of its rate hike process, or by adjusting the long-term benchmark rate. We believe that the Fed will likely use a different “threshold” for each of the three metrics to determine if it has strayed meaningfully from the target level, and estimate this threshold level to be about 1% for GDP Growth, 1.5% for Unemployment Rate and 0.5% for Inflation. To explain the threshold level further, a GDP Growth Rate Change Threshold of 1% implies that the Fed will stick to its current plan as long as GDP Growth remains within ±1% of its long-term estimate for this metric.

Notably, the lowest threshold level for inflation among these three metrics indicates that benchmark interest rates are most sensitive to inflation – reinforcing investor views that higher inflation is likely to speed up the rate hike process.

Don’t Agree With Our Assumptions Here? Feel Free To Use Your Own By Making Changes To Our Model

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