SINGAPORE (Jan 30): The Federal Reserve has been happy to raise interest rates very slowly despite tight labour markets because of low inflation. However, there are now signs that the underlying pace of price rises is close to the Fed target. This means that interest rate hikes will have to continue and we will see more pressure on bonds.

Inflation has been running well below the Fed’s 2% target over the past year, but this is set to change over the next few months, for three reasons.

First, the current 1.5% year-on-year (YoY) inflation rate has been held down due to a peculiar drop in the price level in March last year. As long as comparisons are made with the pre-March 2017 price level, the year-on-year inflation rate will be held back. That will change in 2Q 2018. Even now the underlying inflation rate is running at 1.9% (by comparing the past three months with the previous three) and the two other factors will give a further boost.

Second, oil prices will push up headline inflation and even though the direct impact is stripped out of the “core” inflation measure, there are some knock-on effects across the economy, as we saw in 2011. We expect increased US supply to pull prices back down in coming months, but at the moment crude oil is 25% higher than last year.

Third, the weaker USD (down 9% compared to a year ago, on a trade-weighted basis) will push up the price of imports, which make up 17% of the US economy. This will feed through to higher goods prices.

In this situation – with the unemployment rate already down at 4.1% – the Fed has little choice but to keep on normalising interest rates. We do not expect the Fed to hike at the current meeting, but they are set for another move in March and it looks increasingly likely that they will tighten each quarter this year.

Perhaps a more interesting question is at what level the Fed stops. At the moment the market expects the Fed to stop tightening when interest rates reach neutral levels at around 2.5% (after four more hikes). That seems unlikely, as in previous cycles interest rates always push above neutral in order to cool down an overheating economy. A similar pattern is likely this time around, with unemployment already well below equilibrium.

If we add policy tightening in Europe and rising supply into the US bond market (with wider budget deficits and the shrinking Fed balance sheet) into the mix, this points to continued pressure on US bonds. It is easy to see US 10-year Treasury yields at 3% by the end of the year.  

Richard Jerram is Chief Economist at the Bank of Singapore, a subsidiary of OCBC Bank