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Who’s Right on Future Rate Hikes — the Market or the Fed?

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Two or four?

While the financial markets are predicting two more rate hikes this year, many central bankers are saying the Federal Reserve may raise interest rates four more times this year.

In a CNBC interview on Wednesday, Federal Reserve Vice Chairman Stanley Fischer said the market expectations of the number of future rate hikes are “too low.” And Richmond Federal Reserve President Jeffrey Lacker said Thursday that more than four rate hikes may be needed if oil prices stabilize, the dollar stops appreciating and inflation surges.

In a press event in New York on Thursday, Schwab representatives weighed in on who they think is right: the markets or the Fed.

“We think the market’s probably much closer to right than the Fed,” said Liz Ann Sonders, chief investment strategist for Schwab.

Kathy Jones, chief fixed income strategist for Schwab, added that two more hikes is “a lot more likely” than four.

“The bond market hasn’t been buying … the optimistic Fed forecast for five years, I don’t think they’re going to start buying it this year, unless we actually see inflation pick up,” Jones said.

Jones said the Fed has been “overly optimistic” about the economy and inflation for several years.

Despite Fischer’s comments that two hikes is “underestimating,” Jones isn’t deterred.

“I think he has to go with the party line, right?” she said. “This is what the median projection show. He’s the vice chair. He did say in that interview also, ‘We meet every six weeks or so because things change.’”

(The December Median Predictions from central bankers supports the four rate hikes throughout 2016.)

Jones points out that the Fed research staff presented a study at the October Federal Open Market Committee meeting about what the real neutral federal funds rate would be longer term.

“And they came at zero, meaning anything above a zero real interest rate would slow the economy,” Jones said. “If the Core PCE is 1.4, fed funds is 25 (basis points), we’re at negative 115 basis points in terms of a real fed funds rate right now.”

(The core personal consumption expenditures index is the Fed’s preferred inflation measure.)

The Fed would need to go up 115 basis points to get to neutral over a couple of years, she explained.

“Why would they do that all at once in 2016?” Jones said. “Unless they thought that inflation was really going to pick up. But it’s very difficult to see how inflation is going to pick up this year.”

The FOMC minutes also addressed inflation expectations, which had declined slightly in recent months.

“Many concluded that longer-run inflation expectations remained reasonably stable,” the minutes said. “However, some expressed concerns that inflation expectations may have already moved lower.”

Both Jones and Sonders think that inflation data over jobs data will be the key determinant for future rate hikes.

“I’m not sure the headline ‘Jobs Number’ is as market moving as it was before the initial hike,” Sonders said. “I think its data around inflation – particularly given the minutes and the fact that many said, ‘It was a close call and we really want to see inflation expectations cement the view that we are getting close to our target.’”

Jones agrees that inflation will be the Fed’s “big dilemma.”

“We’re in a very low inflation world. And, a lot of that because of global pressures,” she said. Adding, “they may have a difficult time raising rates even if the economy is doing well.”

— Check out Schwab’s Sonders, Kleintop: ‘Unfinished Business’ to Be Drag on Stocks in 2016 on ThinkAdvisor.


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