A fourth Fed hike this year could trigger economic slowdown, strategist warns

While many may welcome the more hawkish stance from the Federal Reserve after a decade of record-low interest rates, one economist warned that it may actually lead to an economic slowdown.

The Federal Reserve hiked rates for the second time this year Wednesday and is looking at two more for 2018 amid observations of a strong outlook for the U.S. economy. But Jim McCaughan, the chief executive of Principal Global Investors, said there are risks involved.

“The way I interpret this is, one further rate increase is probably the right answer for the rest of the year,” he told CNBC’s “Squawk Box Europe” Thursday, espousing a more doveish route for the monetary policy-setting body. His investment fund, based in the U.S., has $311 billion in assets under management.

“Two further is probably what they’ll do, but they run the risk then of getting to the ultimate level fairly quickly and causing some slowness in the economy, which will bring about an inverted yield curve much sooner than it needs to happen.”

An inverted yield curve is typically a telltale sign of a coming recession, as it indicates that short-term lending is perceived by markets as riskier than long-term lending and therefore the economy is doing much worse in the present than it will do in the future.

McCaughan justified his argument by pointing to what he saw as a disparity between the consumer price index (CPI) figure published by the U.S. Bureau of Labor Statistics and the actual rate of inflation, which he said is lower than the published figure. This is due, the CEO said, to the effect of technology in the U.S. economy improving product and service quality and therefore enabling lower and more competitive prices on many goods that the CPI calculation doesn’t yet take into account.

“So when we get to a reported level of 2 percent for inflation, the usual central bank target, the inflation rate in reality will be only around 1 percent,” McCaughan argued. “This means that a 3 percent ultimate Fed funds rate would be 2 percent real, which is high for a cash rate, and could actually be contractionary on the economy … Or an excessively restrictive monetary policy.” Wednesday’s move by the Fed pushed the funds rate target to 1.75 percent to 2 percent.

The Federal Open Market Committee would beg to differ, saying in its statement, “further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.” This 2 percent objective, of course, is exactly where McCaughan finds fault.

The “symmetric” inflation target also signaled a tendency to let prices run a bit higher, however, before tightening policy further. “So I think they’re into modest policy error territory simply because the inflation targeting is giving them a false signal,” McCaughan maintained.

The veteran investor’s view certainly isn’t shared by all; recent economic forecasts by Goldman Sachs and Bank of America objected to calls of slowdown in the near future, with the latter putting a recession at the earliest in 2021. Goldman Sachs also predicted four rate hikes this year, but said in a previous interview with CNBC that “it is difficult to see the triggers for a recession anytime soon.”