According to the Bureau of Economic Analysis, the economy grew faster in the fourth quarter of 2017 than was originally estimated. The third estimate of GDP growth in the quarter 2.9 percent, was faster than the 2.6 percent “advance” estimate and the 2.5 percent second estimate. It confirms that the economy grew faster than its potential, strongly indicating that the Fed will continue to raise its short-term policy rate.
As illustrated in the figure above, the economy, measured by real GDP growth on a seasonally adjusted annual rate basis, was revised upward in the third estimate of fourth quarter 2017 performance. The higher third estimate reflected stronger growth of personal consumption expenditures, which accounts for approximate 70 percent of the GDP, and private gross domestic investment, private inventory investment in particular. The positive contributions from personal consumption expenditures, private gross domestic investment, government spending, and exports were partially offset by subtraction by imports. A previous post suggested that widening trade deficit in the fourth quarter likely reflected rising interest rates.
The third estimate of GDP growth confirms that the economy expanded faster than its potential level as estimated by the Congressional Budget Office. After failing to exceed its potential growth in the first quarter of 2017, economic growth has now exceeded its estimated potential growth rate for three consecutive quarters. The faster growth of the economy relative to its potential rate of growth further pushes the level of goods services produced throughout the economy above its potential level, indicating that this “output gap” remains positive. Previous analysis illustrated how the Fed typically responds to a positive output gap by raising its policy rate.
Despite expectations of slower growth in the first quarter of 2018, due to moderation in household spending and investment, the most recent projections by FOMC members indicate that, at the median, the Fed will raise rates three times in 2018. Assuming each hike is 25 basis points, the Fed also communicated that, at the median, it will raise rates three more times in 2019 and twice in 2020. The 2019 and 2020 estimates were raised from expectations of two hikes in 2019 and one or two hikes in 2020 communicated in the December 2017 projections.
The figure above plots the Fed’s expectations for rate hikes from the median in its March projections with financial market’s expectations of Fed hikes in 2018, 2019 and 2020. It uses prices of federal funds futures priced on the CME exchange. The 2018 expectation is the spread between the price on February 2018 federal funds futures and the price on January 2019 federal funds futures. The 2019 expectation is the difference between the price on the January 2019 federal funds futures and January 2020 federal funds futures. The 2020 expectation is the gap between the January 2020 federal funds futures and the January 2021 federal funds futures. These prices are listed on the CME and trade daily. The last day of trading for the February 2018 federal funds futures contract was March 1.
The figures illustrates that market’s expectations for Fed rate hikes in 2018 is similar to the Fed’s expectations. In fact, the spread between the April 2018 and January 2019 contract as of March 27th is 47 basis points indicating that financial markets expect two more rate 25 basis point rate hikes in 2018 following the hike in March. However, there is still disagreement between the median Fed expectation and financial markets for the amount of rate hikes in 2019 and 2020. While the Fed communicated that, at the median, 75 basis points worth of rate hikes are expected in 2019 and 50 basis points of rate hikes are expected in 2020, financial markets currently expect one or two rate hikes in 2019 and virtually no hike in 2020.