As I was logging into my bank account the other day, it struck me that for the first time in a decade my children might soon start to see their savings accounts earn a real return. I’ve been happy to show them how their balances have been growing—hoping it will instill good savings habits—but I haven’t had the heart to explain that inflation has eaten away more value than they’ve earned.
Maybe that lesson can wait. Savers have been the sacrificial lambs of U.S. monetary policy since the great financial crisis, with the Federal Reserve using low interest rates as a tool to stimulate borrowing. But that period may be coming to a close. When the Fed meets this week, we expect it to make its fourth hike in short-term rates this year. We expect another two hikes in 2019. That would put the federal funds rate near 3%—very likely the high-water mark in this rate-raising cycle, but still comfortably above our inflation forecast.
We called the faster pace of monetary tightening in 2018
Rising rates were part of our projections for the economy and markets in a research paper we published late last year. We highlighted that the chances of a short-term cyclical rebound in U.S. growth and inflation were underappreciated. A tight labor market, we argued, followed by an upswing in wages and inflation, would justify the Fed’s raising rates to at least 2% by the end of the year. This scenario was not the consensus view; as the chart below illustrates, financial markets at the beginning of 2017 were pricing in a less aggressive path for monetary policy.
Markets underestimated the Fed in 2018 and are doing so again for 2019
Notes: The historical federal funds rate indicates the midpoint of the target range. Market forecasts reflect implied pricing from federal funds futures. Data are as of December 12, 2018.
Sources: Vanguard, Bloomberg, and the Federal Reserve.
Looking back, I’d say our call was spot on. The U.S. labor market continued to tighten throughout 2018, with payroll growth averaging over 200,000 a month and the headline unemployment rate falling 0.4 percentage points to 3.7%, with the help of fiscal stimulus from tax cuts. These strong employment gains contributed to a cyclical acceleration in both wages and inflation. The Atlanta Fed’s Wage Growth Tracker has risen from an annualized rate of 2.9% at the start of the year to 3.7% today, and the U.S. Core Personal Consumption Expenditures Price Index has increased from 1.6% to 1.8%. In response, the Fed consistently ratcheted rates higher, broadly in line with our expectations.
Tougher choices for the Fed in 2019
Looking forward, we expect U.S. economic growth to slow toward a more sustainable level of around 2% next year as fiscal and monetary policy support fade. (See our recent Vanguard Economic and Market Outlook for 2019 for a more in-depth discussion.) In contrast to last year, we don’t expect an upswing in inflation, as the long-term forces of globalization and technological disruption should reassert themselves and exert downward pressure on consumer prices. We don’t see higher wages feeding into higher prices, so inflation expectations should remain well anchored. In our view, U.S. core inflation will remain near 2% and potentially even weaken by the end of 2019.
Given what we see as a very different trajectory for the economy in 2019, we would expect Fed Chairman Jerome Powell and the rest of the Federal Open Market Committee to stop raising rates by midyear amid slowing economic growth and a more benign inflation outlook. The chart above contains our forecasts for 2019 as well as those of the Fed and the markets. It’s worth noting that the markets are again forecasting less tightening than are Vanguard and the Fed.
What will higher rates mean for investors?
A continued tightening of monetary policy in 2019, coupled with slowing growth in the U.S. and abroad, is likely to lead to occasional periods of volatility in both equity and fixed income markets.
Over the longer term, however, higher short-term interest rates across developed markets have led us to raise our outlook for investment returns (albeit very modestly) for U.S. dollar-based investors. That’s the first time we’ve done so in over a decade.
And, of course, positive real rates are good news for savers, like my children, who will finally have a real incentive to keep putting money away.
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