The tax cuts and “elevated asset prices.”

Another rate hike is baked in for the Fed’s meeting next week, which will lift the target for the federal funds rate to a range between 1.25% and 1.50%. “A majority” of economists now expect three rate hikes in 2018, up from two rate hikes just a few weeks ago, Reuters said this morning, based on its poll conducted just before the Senate passed the tax cuts.

The tax cuts are making economists rethink what the Fed will do next year. According to Reuters, “the forecast risks have shifted toward higher rates, and faster.”

But are expectations still too low? Could an increasingly hawkish Fed surprise the markets with more rate hikes?

The three rate hikes next year that economists are now expecting just put them in line with the Fed’s own projections, published well before the tax cuts had become a nearly sure thing.

“This is about just getting back to a neutral level where monetary policy is neither encouraging growth nor pushing against growth,” Brett Ryan, senior US economist at Deutsche Bank, told Reuters. The bank now is expecting four rate hikes in 2018.

“The Fed is still accommodative at the moment and we are still some ways away from the neutral fed funds rate which would in the Fed’s view be closer to 2.75%,” he said. “The Fed can hike without slowing the economy.”

What has been seeping through the Fed’s communications all year is a concern over “elevated asset prices” and that, despite the Fed’s effort to “remove accommodation,” financial conditions in the markets have not tightened.

The dollar has fallen since the rate hike a year ago, stock prices have soared, bond prices have risen, and therefore yields have fallen, including junk bond yields — signs that investors are more and more chasing after higher and higher risks. This is the definition of loosening financial conditions, the opposite of what the Fed has set out to accomplish over the past year.

Where rate hikes have become effective is with yields at the shorter end of the curve – debt with maturities of up to two years. Those yields have risen sharply, and prices have come down. But these moves have not filtered into the rest of the markets.

Inflated asset prices – and what they could do to the economy when they suffer “a sharp reversal” – made their way once again into the Fed’s communications, this time into the minutes of the last FOMC meeting:

In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances. They worried that a sharp reversal in asset prices could have damaging effects on the economy.

National Bank of Canada’s Economics and Strategy came out with a note this morning, warning that economists and the markets might be underestimating the hawkishness of the Fed next year:

Even considering the low rate of U.S. inflation, monetary policy in the world’s largest economy is arguably too loose. It’s the first time since the 1970s that real interest rates are in negative territory despite a positive output gap. Some Fed members are now even expressing concerns about financial imbalances fearing “a sharp reversal in asset prices” according to the latest minutes. Recently approved tax cuts by Congress also warrant normalizing monetary policy. As such, we believe the Federal Reserve will raise interest rates more than what markets are currently expecting in 2018.

“Markets just don’t believe the Fed can significantly tighten monetary policy,” the team, led by Stéfane Marion, Chief Economist and Strategist, wrote in the note:

The fed funds rate is expected to be below 2% by the end of 2020, in sharp contrast to the Fed’s own view that rates will be closer to 3% by then. This market view has no doubt been shaped by years of disappointing readings on both wage growth and the overall inflation rate which have seemingly eroded trust in the Fed’s ability to hit its 2% inflation target.

Both, Janet Yellen and Jerome Powell, who will succeed her in February, have been on the same page, emphasizing over and over again that the Fed should continue the “gradual” process of normalizing monetary policy.

Normalizing monetary policy is a rubbery concept. A number of Fed governors have suggested that the “neutral” rate would be around 2.5%. Deutsche Bank above said it would be “closer to 2.75%.” “Neutral” means that the “accommodation” of the past nine years has been “removed,” as the Fed likes to phrase it. Any actual tightening of monetary policy would start at that point. But for now the entire conversation is about “removing accommodation.”

And the tax cuts are adding fuel to the brush fires that the Fed is trying to step out. The Fed’s projection of three more hikes next year didn’t take into account any potential tax cuts. A little over a year ago, the Fed stopped flip-flopping and has since done everything it said it would do, including the QE unwind that commenced in October. But markets have simply brushed off the Fed. This might set the scene for these willfully blind markets to get tripped up by a hawkish “surprise” next year.

Even as lawmakers cobbled together a tax-cut bill that would cut revenues by about $1.5 trillion over ten years, the gross national debt has spiked $723 billion over the past 12 weeks, to 105% of GDP. Read… US Gross National Debt Jumps $723 billion in 12 Weeks, Yellen “Very Worried about Sustainability of US Debt Trajectory”