How long will the cycle last?

In a nutshell

• Strong growth momentum, ongoing fiscal support, a tight labour market and mounting inflationary pressures all suggest that the Fed will deliver on its plan to further tighten monetary policy over the next few quarters.
• While a number of risks are worth monitoring, the determinant factors for US monetary policy will remain domestic inflation and employment.
• Looking at the next few quarters, interest rate market expectations about the path of the policy rate seem too conservative.

Having delayed “lift off" for longer than anticipated, the Fed has now delivered more than most thought likely. September saw the eighth hike of the cycle, taking the policy rate to 2.25%. In the meantime, the Fed has also been scaling down its balance sheet, now reduced to just below USD 4 trillion – and continues to let assets run off.

The objective of monetary tightening is to prevent overheating, i.e. the risk of growth rising too far beyond the economy's potential, triggering high inflation that could later prove hard to rein in. In this regard, the current picture suggests that the Fed's tightening cycle still has some way to go. Strong growth momentum, supported by the ongoing fiscal boost, has kept job creation running at a pace roughly double that needed to keep unemployment stable. Meanwhile, inflation, which is now back at the Fed's 2% target (see chart IV), faces near-term upside risks owing to a tight labour market, little spare capacity, higher commodity prices and the impact from tariffs.

The list of risks to a steady policy outlook is long: emerging market turbulence, domestic issues such as political uncertainty, rising trade tensions, or financial risks like those related to a flattening yield curve. Each of these can have an impact at the margin – if inflation disappoints, or when growth momentum starts to slow. But we would highlight that unless these factors are seen to exert an effect on its domestic mandate, the Fed has shown an intention to stay the course – which means that US inflation and employment remain the most critical indicators to watch.
 

Our base case is that the outlook for Fed policy is tilted to the hawkish side. This contrasts with market expectations, still doubtful of the Fed's intention to deliver further tightening (see chart V). How this divergence plays out will be a critical development in coming quarters – both for US interest rate markets and for many other asset classes, given the global influence of US monetary policy.