As expected, the US Federal Reserve (the Fed) raised the target for its federal funds rate by 25bp to 2%-2.25% at the 25-26 September meeting of the policy-setting Federal Open Markets Committee and 12 of the 16 voting FOMC members signalled it would be appropriate to raise rates again in December. This is the fourth consecutive quarter in which the Fed has tightened monetary policy.
Stance of US monetary policy no longer accommodative
The Fed decided to remove from its Policy Statement the phrase that “the stance of monetary policy remains accommodative”, signalling that it now considers that its recent and future expected rate increases will remove monetary accommodation. The FOMC raised its real GDP forecasts for the second half of 2018 and, modestly, for 2019, expecting it to be appropriate for the Fed to raise its funds rate to above the median FOMC member estimate of the neutral rate between 2019 and 2021 (3.1%-3.4%).
A pick-up in the annual rythmn of federal funds rate rises in this economic cycle
The first federal funds rate increase of this expansion cycle was in December 2015. In 2016, the Fed raised rates once (December), and then three times in 2017. Currently, the Fed is on course to raise rates in every quarter of 2018.
US short-term rates have almost converged towards the Fed’s 'dots' in 2018, but remain much below the 2019 'dots'
Currently, market pricing (see fed funds futures and OIS pricing in Exhibit 1 below) does not integrate the Fed's tightening cycle taking official rates to as high as the level members of the Federal Reserve anticipate (see FOMC dots median in Exhibit 1).
Market pricing has, however, evolved considerably: a year ago (i.e., before the cut in US corporate taxes and Jay Powell's arrival at the Fed as chairman), the market expected the Fed to raise rates only twice in 2018. Recently, the 2.9% year-on-year increase in average hourly earnings for September 2018 led to a significant upward shift in market expectations.
Our view is that the Fed will deliver
Cedric Scholtes, Head of the Interest Rates team at BNP Paribas Asset Management, takes the Fed at its word - he expects it to continue raising US rates at a steady, gradual pace (i.e., once a quarter) in both 2018 and 2019 until a peak is reached at around 3.50% in 2020.
Exhibit 1: US short-term rates have almost converged towards the Fed's 'dots' in 2018, but are still significantly below the 2019 'dots'Source: Bloomberg, BNP Paribas Asset Management, as at 26/09/2018 (prior to the FOMC meeting)
For previous graphs of the week, click here.