The Federal Reserve is widely expected to raise rates on Wednesday but the big question for the market is whether June marks a pause in the current tightening cycle or if policymakers display a willingness for at least one more hike in 2017.
The Federal Open Market Committee (FOMC) meets June 13-14 in what most think is going to be a rubber stamp job on hiking rates. Market expectations put a 25 basis point rise in the target federal funds rate at 99.6%. This would be the fourth in the current cycle and third since December.
So with June a done deal, the big question for the markets is what next.
Fed officials believe there will be three rate hikes this year, leaving room for one more after June. But financial conditions are easing and the yield on the 10-year Treasury note has declined along with the dollar to levels last seen before the Trump-reflationary trade took off in November.
Markets think there is just a 23% chance the Fed will hike again in September and a roughly 40% chance of one by December. So markets currently don’t currently entirely believe the Fed’s current dot plot, which reveals consensus around the target fed funds rate being between 125-150 bps by the end of the year, with the bias slightly higher overall (see chart below).
Economic data is mixed. At the last meeting FOMC members noted that growth has slowed but importantly, suggested this would be ‘transitory’ and growth will pick up. They said near term risks to the economy remain balanced and this is unlikely to change.
Minutes from the meeting sounded a touch more dovish as policymakers thought that “it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory before taking another step in removing accommodation”.
Jobs data has started to slip a touch and this may be a cause for concern. May’s nonfarm payrolls missed expectations at 138k, while the figure for March was revised down from +79,000 to +50,000, and the change for April was revised down from +211,000 to +174,000. This suggests the US labour market was not nearly as healthy as we thought in the tail end of Q1 and the start of Q2.
Unemployment continues to tick lower – down to 4.3% – but any temptation to accelerate tightening is tempered by hidden labour market slack, which is greater than the headline figures suggest and means there is little pressure on wages and inflation.
Consumer spending is rebounding, though and as a key drive of the US economy this ought to provider succour to the hawks. Latest figures show consumer spending accelerating at its fastest pace this year in April as the US comes out of a period of slacker household spending that helped keep 1Q GDP growth on its heels (+1.2%, short of the 2.1% print in 4Q 2016). This has helped the Atlanta Fed estimate 2Q GDP growth of 3%, although the trend is showing this forecast being revised lower. Fed officials currently think GDP will expand at a rate of 2.1% in 2017 so we are counting on improved performance through Qs 2-4 to deliver given the soggy start to the year. Industrial production accelerated in April but business spending and retail sales have been less impressive.
FOMC meeting: what to watch
Due out at 13:30 (BST) ahead of the FOMC release at 19:00 the US CPI inflation readings will be closely watched. Economists see the pace of price growth decelerating to 2% in May, having fallen to 2.2% in April from a peak of 2.4% in March. Inflationary pressures do not seem to be getting out of hand. Core inflation, which strips out volatile food and energy prices, remains at a fairly subdued 1.9%. The current pace would suggest the Fed can tighten at a fairly modest pace but should not be rushing things. The inflation data comes out alongside retail sales figures and while softer-than-expected numbers won’t affect deliberations this week, they could shift the outlook on a September hike.
The all-important dot plot will tell us where FOMC members think rates will be this year and through to 2019. The data is watched closely as it indicates whether rate-setters themselves are veering towards a tightening or easing bias based on their expectations of financial conditions and economic forecasts. There is not expected to be much change from the March projections so a shift in either direction could move the markets.
There is some discussion around when the Fed will start to shrink its $4.5tn balance sheet and we expect further details from the Fed this week. If intent on reducing the size of the balance this year it will have to start communicating soon about when and how this will happen. The Fed might choose to alter language on starting roll-offs in September by saying that it the process of interest rate normalisation is well underway. Currently the Fed is rolling over its holdings and says it will do so “until normalization of the level of the federal funds rate is well under way”. Officials have already discussed an approach based on gradually increasing caps on the dollar amounts of Treasury and agency securities that would be allowed to run off each month. The caps would initially be set at low levels and then be raised every three months. As the caps increase, reinvestments will decline and the balance sheet shrunk.