Federal Reserve meeting – potential for hawkish surprise could be overstated

The Federal Reserve is a dead cert to raise rates on Wednesday, so the key question is how far and how fast the US central bank will tighten monetary policy this year. Attention will shift to the signals for future hikes outlined by the Fed’s ‘dot plot’, as well as the post-meeting press conference with chair Janet Yellen.

Fed officials believe there will be three 25-basis-point increases in 2017, the first of which is almost certain to be announced at the March 15th meeting. But the policymakers on the Federal Open Market Committee could raise this to four.

Markets are already pricing in the possibility. Fed funds futures prices indicate a roughly 20% per cent that we’ll see four rate hikes this year, although the consensus is still for 3.

Several analysts have suggested that the bank will tilt to the hawkish side and shift to four hikes this year. The Fed may also signal its intention to pare back its $4.5 trillion balance sheet; a move that could send Treasury yields soaring. The Fed doesn’t want to be seen to be trailing events and playing catch up, particularly with Donald Trump’s promise of lower taxes, higher spending and deregulation. His first budget is due the day after the Fed meeting and is certainly a major factor – for various reasons still largely unknown – which makes predicting the path of Fed tightening all the harder to predict.

Risks remain however and while there is a lot of talk about a ‘hawkish surprise’, it would be just that – a surprise. We have to consider the risks that the Fed faces in raising rates too quickly. It could tip the US economy into reverse gear at precisely the wrong moment. Markets are not used to the pace of tightening being discussed. Trumps pro-growth policies are so far just proposals – we are yet to see anything really concrete

While there is a one in five chance of four hikes, there is a roughly 33% likelihood of just 2 increases to the fed funds rate. So we have to assume markets expect the Fed to stay pretty loose. The Fed may judge that the risks from an inflation overshoot as not as great as a sudden tightening in financial conditions.

Moreover it’s important to remember that policymakers are not going to decide on how many hikes there will be at this meeting. The Fed will base any future decisions on incoming data and that raises the possibility it could refrain from further hikes if wage growth, inflation, job creation and financial conditions are shakier. That said, there is a case for the Fed to use this opportunity to move away from its data-dependent mantra. It could start to make the ground in the markets itself rather than waiting to see and responding.

Last week’s very strong jobs report supports the case for rates to rise but job creation has so far not been the problem. Lacklustre wage growth, which crimps sustainable inflation, backs the case for the Fed to remain tilted to the dovish side. Janet Yellen is a natural dove and it could take bit more before she signals a hawkish pivot after a decade of accommodation.

Like Mario Draghi at the ECB, although to a much less extent, there is a risk of premature tightening leading to a taper-tantrum type event that roils financial markets and leads to instability that shakes investor confidence.