Soaring post-election consumer confidence and healthy data underscore the certainty of a rate hike this Wednesday.
The growth and inflation forecasts, and the 2017 rate projections, are unlikely to change much from September, even as unemployment is likely to be tweaked lower.
Next year, a still mostly inertial inflation and a reactive rather than pre-emptive Fed will likely keep the rate base case at two hikes, with perhaps a third in reserve as insurance.
But by March, rate hikes may quicken in 2018 in response to the expected fiscal policy boost, and could cross into an outright tightening above neutral levels in 2019.
December 12, 2016
It is an unusual Federal Open Market Committee meeting when a rate increase draws barely a flutter of market interest, but the anticipation for this week’s year-end meeting is all about what it may portend, if anything, about next year’s policy path amid the expansionary economic policies that loom under the incoming President Donald J. Trump.
*** The FOMC is all but certain to raise the federal funds target to 50-75 basis points on Wednesday. The statement should be fairly upbeat on the outlook, and may note risks are now “balanced.” It could even include a passing reference to a potential upside fiscal impact, though it is far too early for fiscal and tax policy changes to alter the baseline forecast. The unemployment rate will probably be tweaked lower, but the inflation forecast is unlikely to change much, if any. And we don’t expect the rate dot projections to change all that much either, more or less stabilizing after the dramatic dot downshifting through this year. ***
*** We still think December will mark the peak of Fed dovishness (see SGH 11/10/16, “Fed: Post-Election Reaction Function”) and that the first signal of changes in the FOMC rate expectations could come at the March meeting in a modest, upward migration of the rate dot projections. A third rate hike in the long policy normalization process, however, is unlikely before June. And for all the heady expectations with fiscal policy and the arrival of new Governors to the Board, the Fed’s base case is more likely than not to stay at two rate hikes in 2017, with perhaps a third hike in reserve as insurance. ***
*** Indeed, inflation dynamics, not fiscal policy, will drive the Fed’s near term policy path. And even amid a likely “high pressure economy” next year, prices are still expected to be relatively restrained by the strong dollar and flattened linkages between wage growth and inflation. What’s more, a FOMC majority next year is likely to tolerate any overshoot of the 2% inflation target, suggesting the Fed will be more reactive than pre-emptive to the eventual impact of the fiscal stimulus. But the median pace of rate hikes could steepen in 2018, and cross into an outright tightening above neutral in 2019. ***
Wednesday’s Likely Takeaways
The highly likely rate hike on Wednesday has been so thoroughly telegraphed by Fed officials that the market and media chatter has been mostly focused on how or if the Fed will indicate a faster pace of rate tightenings in response to anticipated boost to fiscal policy and tax cuts in the first year of the Trump Administration.
The statement itself should carry a fairly upbeat tone in its description of the state of the economy and its outlook, and as befitting a rate increase, the risks may be tweaked to “balanced” from the “roughly balanced” phrasing in the November statement.
Wednesday’s key takeaways are likely to come in Chair Janet Yellen’s post-meeting press conference remarks. We expect Chair Yellen to be quite measured in her remarks, something of a “watchful waiting” stance for the most part. But even if she repeats her guarded remarks at the Joint Economic Committee testimony a few weeks ago, that it will take a while for the tax and fiscal plans to take effect, for instance, anything she adds, however carefully worded, about a possible quickened pace of rate hikes, is likely to be taken quite hawkishly by the markets when framed against the backdrop of an actual rate hike.
So we would not be surprised if she might find a way to note the Fed doesn’t see the need to raise rates preemptively against a possible boost to fiscal spending, or that the Fed is still unlikely to move away from its cautious, gradual pace in the near term.
The Fed is watching the market’s steepening of the yield curve and the appreciation in the dollar closely and it is far more of an immediate concern than the eventual effects of changes in the fiscal and tax policies. For now, however, we understand the market pricing is seen as fairly benign, unlike the effects of 2013’s “taper tantrum,” moving if perhaps prematurely in response to likely changes in the outlook rather than purely as a misread of Fed policy intentions when the economy was still so fragile. But that said, no sense in tempting fate by lending further wind to the sails of a market’s aggressive pricing on the “Trump trade.”
Fiscal Policy and the Forecasting Process
We do think in fact there are likely to be precious few new clues for changes in the Fed’s near outlook and rate path for next year in Wednesday’s Summary of Economic Projections and the rate dot plots. The reason is simply that it is just too early for there to be much for the Fed to work with. As we recently wrote (see SGH 11/10/16, “Fed: Post-Election Reaction Function”), none of the necessary detail on the timing, scale or composition of the proposed changes in federal fiscal outlays or tax policies would have been available for the forecasts prepared for this week.
And we doubt that will change all that much by the time of the January FOMC meeting, from which Chair Yellen draws on the staff work and Committee discussions for her bi-annual Monetary Policy Report to Congress — the Humphrey Hawkins testimony — some time in February.
For the most part, fiscal policy effects in the forecasts are based on current law, or the impact of the existing level of government spending, and those are what goes into the rate dots, which reflect the assumed appropriate policy path built into the forecast. Staff, though, do use a fair degree of judgement, and can and do prepare forecast simulations, based on various scenarios of higher or lower fiscal projections to gauge the impact on the outlook.
They often do so, for instance, at the request of a Governor or their District Bank President. And there will no doubt be at least some discussion and acknowledgement that the assumptions on the outlook that had been shaping the policy path this year could be on the eve of some major changes next year. But how or by how much is anyone’s guess for a while.
We suspect that caution about the changes in the fiscal impulse and what it will mean for the rate policy path won’t begin to show up in the SEP rate dot projections until the March meeting at the earliest.
By then, while budget or tax bills would be far from passage, staff should at least get a decent sense of the fiscal year 2018 budget plans from the President’s annual budget presentation, normally in February, or usually by mid-March, when the Senate and House Budget Committees draft budget resolutions. Likewise on the tax front, the House Ways and Means Committee and Senate Finance Committee may be far enough along at that point, especially under the priorities of the “first 100 days agenda” of the Trump White House, to give the Fed staff enough to work with.
And in an economy already operating at or very near full employment with almost no remaining output gap, that may be enough for some FOMC members to begin tweaking their rate dot projections modestly upward for 2017 and more sharply in 2018 and 2019. It would mark the first upward migration in the Committee’s rate projections since they began dramatically marking down rate forecasts on the basis of the lowered estimates of the equilibrium, or neutral, policy rate.
But looking ahead to the most likely pace of rate hikes, we think it is likely to be summer at best before the overall fiscal and tax mix is clear enough on top of the inflation trends to warrant a third rate hike in the current pace of policy normalization. That is to say, a rate hike before the June meeting is unlikely.
Slow Inflation and a Reactive Fed
Even if Committee members in March have moved their 2017 rate projections up enough to lift the median from two to three rate hikes, we still suspect the FOMC will be reluctant to raise rates twice more after June before the end of 2017. Adding that third rate hike in 2017 could always come as an insurance move in case an upside surprise on inflation forces the Fed’s hand, but under the current expectations, it is for now a lower probability.
The reason for that is twofold. First, the behavior of inflation, not fiscal policy, will be the primary policy driver in 2017, and for now the Fed still expects a slow moving, inertial inflation through much of next year. The December 2017 SEP inflation forecast, for instance, will probably stay at the 1.9% mark of the previous July and September projections.
To be sure, market inflation expectations already are moving higher, but for the most part the movement is more about the flushing out of the last of the deflation risks that dominated much of the market thinking through this year. And the spike in bond yields and the appreciation of the dollar are serving to modestly tighten financial conditions, adding a damper on near-term inflation pressures.
Otherwise in the year ahead, goods inflation is seen as still coming out of a long and powerful deflationary period, driven by the strong dollar exchange rate effects and sheer scale of the global competition in the the goods sector and the prior investments to improve manufacturing productivity. Getting out from under that downward pressure is going to take some time.
The real upward price pressure is expected on the service sector side, driven largely by faster and higher wage growth. But while service sector inflation has traditionally run higher at 3% or more than goods inflation, it too went through a period of strong deflationary pressures the last couple of years, having dropping down to around the 2% level that had translated into the persistently low core inflation of around 1% that had triggered deflation concerns.
All of that is assumed to be slowly trending back up, but that too may take a while to make its way into higher core price measures. That may prove to be the case especially when the linkage between higher wages and the pricing power of companies to pass on their higher labor costs in higher prices that can stick is still so stretched.
And second, in terms of the reaction function, our sense is that a majority of the 2017 voting members of the Committee — even with the arrival of new Trump White House appointed Board Governors — will be willing to tolerate any modest overshoot of the 2% inflation target in a rising but hardly accelerationist inflation further down the forecasting horizon.
In other words, we think the Fed will be adopting a far more reactive rather than pre-emptive policy stance, even on the eve of the Trump Administration’s anticipated boost in federal spending.