The Federal Reserve is odds-on to raise rates this week but that does not mean this is a dead meeting. The outlook for the future path of rates remains highly uncertain with the Fed itself wrangling over whether it can stick to at least three 25-basis-point increases next year.
With the hike fully expected by markets, the focus for the meeting this week is on the updated economic projections, including the so-called dot plot, as well as the language employed by Janet Yellen in the post-meeting press conference.
The economic picture seems barely altered: inflation is still not firing despite solid jobs and growth numbers. Apart from the changes to the FOMC itself, the big difference from the September meeting is the progress on tax reform.
The dot plot and other economic projections will convey less conviction to the markets than before since there is considerable uncertainty about the make-up of the Fed next year. Although Jerome Powell is all but secure as the next Fed chair – and one that will not break with the Yellen doctrine – there are four seats on the board of governors to fill. This makes it problematic to read too much into the projected path of monetary policy. Nevertheless, changes to forecasts will be treated with due reverence and any upward or downward revisions will drive short-term price action in the dollar and Treasuries.
When the most recent dot plots were published in September officials had yet to price in fiscal stimulus into their forecasts. FOMC members may not officially recognise the impact of tax reform, preferring to wait until it becomes law. However, with the bill looking likely to pass, the Fed may find scope to turn a touch more hawkish.
If policymakers decide to factor in tax reform, it could see the median fed funds rate projection pushed up slightly for 2018 and 2019.
While the FOMC may prefer to ignore fiscal reforms until they are on the statute book, markets will look to Yellen’s press conference for a clearer indication of how policymakers view the impact on monetary policy.
Complicating things for the FOMC is a flattening yield curve. Rising short term rates and flat longer-date yields mean the yield curve has flattened considerably in 2017. If the curve goes beyond flattening and inverts – i.e. short-date debt carries a higher yield than longer-dated debt – a recession often follows (see chart). The risk is that the Fed tightens short-term rates too quickly without longer-end of the curve following suit, resulting in a ‘policy mistake’. Doubts about the impact of tax reform on longer-term growth potential mean the effect of fiscal reform on longer-dated yields has been less than some forecast.
What the data indicates and how the economic projections could change:
US GDP expansion has kicked up a gear or two in the last two quarters of 2017. Following the rather lacklustre performance in Q1, (+1.4%), growth has run at above 3% year-over-year in the following six months. Q2 recorded 3.1% growth, the fastest pace in two years with the final reading higher than the first two estimates. The second reading of the Q3 print was a very robust 3.3%, which was also ahead of expectations.
Estimates for the fourth quarter are, as ever, in a pretty wide range. The New York Fed Staff Nowcast stands at 3.9% for Q4 and 3.1% for 2018:Q1. The Atlanta Fed’s estimate has eased to 2.9% for Q4. Assuming a 3% expansion in Q4, the Fed would have to revise its 2017 median change in real GDP projection up from 2.4% in September to 2.6%.
Stronger growth in the last nine months may also help the FOMC firm up its 2018 projections, with it seemingly likely that members will see growth next year around 2.5%, against a 2.1% median forecast in September. We also envisage the Fed will upgrade its growth projections for 2019.
Anticipated effect: Hawkish
The unemployment rate has continued to fall since the last round of economic projections. The Bureau of Labor Statistics reported on Friday that unemployment was steady at 4.1%, its lowest level since 2001 and down from the 4.4% at the time of the last projections and 4.7% at the start of 2017. The Fed will likely revise down its unemployment rate projections by 0.1-0.2 percentage points, implying a sub-4% rate in 2018 and 2019.
Anticipated effect: Hawkish
Earnings growth remains more muted, consistent with the trend throughout 2017. The latest data continued the annual rate of wage growth at 2.5%. The continued lack of uplift in earnings in spite of falling unemployment continues to exert a downward influence on inflation expectations.
Anticipated effect: Neutral
On inflation, there is better news which may see policymakers be less concerned that subdued price growth becoming more entrenched. Officials, including Janet Yellen, have stressed that the undershoot in core inflation – which has lasted for more than five years – is down to transitory factors but in recent meetings they have started to express worries that it might reflect something more persistent.
The core personal consumption expenditures (PCE) price index (the Fed’s preferred gauge) climbed by 0.2 per cent in October. Through October, the core PCE rate was at 1.4% year-over-year. Although this is down from the 1.8% area achieved in the early part of the year, there are signs that the decline in the rate over the summer months has been arrested.
Whilst showing signs of improvement, the Fed has been over-optimistic on PCE inflation projections and the improvement is unlikely to see the Fed alter its outlook from September, which stood at 1.5% for 2017, 1.9% for 2019 and 2.0% in 2019.
Anticipated effect: Mildly hawkish
New dot plots?
So will we get a new set of dots, or will the FOMC copy and paste September’s outlook (below)?
In the last dot plots the two most dovish members had forecasts the fed fund rate at 1-1.25% in 2018. With the hike to 1.25-1.5 %, they will be forced to capitulate and this will shift the median rate northwards a shade. A stronger economic growth trend may also nudge one or two of the next cohort of dovish members to join the consensus around the 2-2.25% mark.
Beyond this, the question is whether Fed officials start to factor in tax reform. If they do it may signal a median fed funds rate in the region of 2.3-2.5% in 2018.
Financial conditions continue to ease despite the Fed hiking rates. The weakness in the US dollar throughout 2017 has contributed a degree of easing to compensate the Fed’s actions and with the market coming around to 3 hikes next year it will take the Fed to signal consensus on 4 hikes to significantly move the needle for USD.
The barriers for the USD to rally are higher still as the market has traditionally been slow to accept the Fed is able to tighten as quickly as the dots indicate.