The just-released short essay from Federal Reserve Bank of Dallas President Rob Kaplan is thoughtful and straightforward and his implications for the U.S. economy are worth reading.  In summary, he foresees:

  • 2018 full year real GDP growth of 3.0% with inflation in the neighborhood of the Fed’s 2% target during the remainder of 2018
  • The unemployment rate – currently at 3.9% – dropping to 3.5% by the second quarter of 2019
  • As a result, we are in a tight labor market that will increasingly constrain economic growth.

Very importantly, Rob believes that the “neutral rate of interest” (i.e. the federal funds rate at which monetary policy is neither accommodating nor restrictive) is at a range of 2.50%-2.75%.  With the current fed funds rate at 1.75%-2.00%, it would take approximately 3 of 4 more federal funds rate increases of 0.25% to get into the estimated neutral level range.  At that point, the Federal Reserve would likely step back and assess the outlook for the economy and look at a range of other factors – including the levels and shape of the U.S. Treasury yield curve – before deciding if further increases in the fed funds rate are warranted.

Alan Zafran, Senior Managing Director and Wealth Manager of First Republic Private Wealth Management, summarizes the key points of the article as:

  1. The Fed is aiming to gradually raise the fed funds rate to its perceived neutral rate without raising the rate too slowly (which could let inflation accelerate) nor too quickly (which could raise borrowing costs too high on the margin and thereby inadvertently slow down economic growth and increase the risk of a recession).
  2. If the neutral rate is only 2.50%-2.75%, then long-term U.S. Treasury rates are unlikely to surge meaningfully higher than where they trade today, with perhaps the 10-year U.S. Treasury yield eventually trading at a modest premium (near 0.50%) above this range until another economic cycle (recession and then recovery) occurs.
  3. The fact that the 10-year U.S. Treasury yield (2.82% currently) is only 0.22% higher than the 2-year U.S. Treasury yield (2.60% currently) is telling me – and the Federal Reserve economists – that expectations for future U.S. economic growth are sluggish and that this year’s 3.0% real GDP growth will taper back down in the years to follow.