Future rate hikes will inevitably depend to some degree on the timing and magnitude of an economic recovery.
The Federal Open Market Committee issued its latest statement on June 10 and, unsurprisingly, held the federal-funds rate at 0%-0.25% with a unanimous vote. There really is no debate that rates ought to be at zero for now, unless you’re in the negative-rate camp. Instead, the real debate is how long rates will stay at zero. This is a key consideration for investors that will affect valuations and profitability timing for rate-sensitive sectors, including the banks. Future rate hikes will inevitably depend to some degree on the timing and magnitude of an economic recovery, which itself will be hard to predict. But we think the conversation is increasingly shifting away from the timing of a generalized economic recovery and is moving instead toward inflation targeting and reaching full employment, both of which could delay rate hikes until long after even a robust economic expansion. As such, we will be adjusting our rate forecast for the U.S. banks, which will lower net interest income in the medium-term years of our forecasts, as we previously expected rate hikes in late 2021 and 2022, which now seems increasingly unlikely. We still expect that rates will eventually rise and that the current adjustments will cause a low-single-digit adjustment to our fair value estimates.
For this meeting, the FOMC released the Federal Reserve’s latest series of economic projections, with the Fed’s members and presidents predicting a decline in GDP of 6.5% in 2020 followed by growth of 5% in 2021 and 3.5% in 2022. The Fed now expects inflation to stay under 2% through 2022, the fed-funds rate to stay at zero through at least 2022, and unemployment to be at 5.5% in 2022, still above prepandemic levels. While the projections through 2022 changed materially, the longer-run estimates did not move, other than a 0.1% decrease in the estimate of longer-run GDP. This largely aligns with our own analysis, as we don’t expect the same hit to long-run GDP that occurred after the 2008 downturn. We think the main takeaway is that the Fed is not expecting to raise rates for years, even as the economy recovers through 2022. Further, chairman Jerome Powell emphasized that one of the lessons the Fed has learned from the previous economic expansion is that the economy can have very low unemployment without having inflation or financial imbalances. All of this implies to us that the Fed will keep rates lower for longer and likely will not feel any pressure to raise rates, even if the economy is booming, as long as we can avoid excess inflation and signs of financial excess and as long as unemployment remains above a mid-3% range. Based on many factors, it is not a given that inflation should tick up, even in a strong economic expansion, and we think the Fed would even be comfortable with an inflation rate above 2% for an extended period. We no longer think this is as much a debate about the timing of an economic recovery but instead about subtle shifts in policy and how we once again reach full employment.?
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