A distinctly more hawkish tone recently from the Federal Reserve (Fed) in recent days has boosted the probability of a US rate rise, marking the second step by the central bank towards monetary policy normalisation in less than six months.
In December 2016, when the Fed held its latest policy meeting that included updated forecasts for the fed funds rate by individual policymakers (the quarterly Summary of Economic Projections (SEP)), the median forecast rose for the first time in years. The median forecast for the main policy rate at the end of 2017 increased by 25bp from 1.125% to 1.375%. With the fed funds rate currently at 0.50% to 0.75%, that implied three rate rises in 2017.
The Fed does not specify a path for these increases, but given the now stable economic growth and gradually falling unemployment, we believe it would not make sense for the Fed to pause on rate rises in the first half of the year and then implement accelerated increases in the second half.
Of course, these forecasts are not set in stone
At the end of 2015 the Fed appeared to be looking for four rate rises and in the end there was only one – see Exhibit 1 below.
Exhibit 1: The FOMC policy rate projections versus reality (graph shows the forecasts each December since 2012 by members of the Federal Open Markets Committee (FOMC) for the the key federal funds rate in the forthcoming year relative to the actual changes in the fed funds rate)
We should note that the dispersion of forecasts among policymakers was high. The two most dovish members foresaw only one rate rise and the most hawkish member anticipated a rise in the the fed funds rate to 2.125% by the end of the 2016, or 125bp higher than it actually is today. Fed policy is, as always, data-dependent. This mantra was repeated in the press statement after January’s monetary policy meeting.
Recently the Fed has sounded more hawkish
In her semi-annual testimony before the US Congress on 14/02/17, Fed chair Yellen said that waiting too long to remove accommodative monetary policy would be unwise. According to Yellen the economy is moving towards the Fed’s goals on inflation and unemployment and keeping policy too accommodative might mean that interest rates will have to be raised rapidly eventually, which would in turn risk disrupting financial markets and pushing the economy into recession. She strongly suggested that rate rises will be discussed at the upcoming monetary policy meetings. That does not specifically point to the FOMC meeting in March, but it is certainly an option.
This relative hawkishness was also reflected in the minutes of the January FOMC meeting. Many at the policy meeting saw the need to raise rates fairly soon. A few noted that raising rates in a timely manner, potentially at an upcoming meeting, would give the Fed greater flexibility in responding to subsequent changes in economic conditions. Several policymakers warned that waiting too long would run the risk of an overheating economy. There was a broad consensus that discussions about the size of the Fed’s balance sheet and reinvestment of maturing bonds should start soon, but this topic was not discussed in January.
On 28/02/17 New York Fed President Dudley said in a TV interview that the case for Fed tightening has become a lot more compelling, mentioning animal spirits and the fact that sentiment had improved a lot (although these confidence gains have not yet translated into spending).
Fed expected to prioritise rate rises
In short, the Fed sees enough progress in the rates of inflation and unemployment to justify further rate rises. On balance, the risks now seem to be of an overheating economy and no longer deflation. The Fed wants to raise rates to have its traditional monetary tool of fed funds adjustments back. For the time being it will not tighten financial conditions both through rate rises and balance sheet reduction. Rate rises take priority so that the Fed can regain traditional policy flexibility. Balance sheet reduction will only start when the Fed has moved rates far enough above the zero lower bound, probably at least above 1% for the fed funds rate.
Having said this, if bond yields continue to be unresponsive to fed funds rises, the Fed may decide to bring forward balance sheet reduction. On 27/02/17 the pricing of fed funds futures suggested a 40% probability of a US rate rise in March. Since Dudley’s remarks on 28/02/17 the probability of a March rate hike has surged to around 80% (see exhibit 2 below). In the eyes of the markets, the relevance of the March meeting has significantly increased.
On 3 March markets will therefore pay very close attention to Federal Reserve Chair Janet Yellen’s speech in Chicago. This will be Yellen’s last before the Fed ‘blackout period’ in the run-up to the FOMC meeting on 14-15 March (this will be a meeting associated with a SEP and a press conference by Chair Yellen).
Exhibit 2: The probability ascribed by Fed Funds futures to a rate hike by the US Federal Reserve has risen sharply in the first few days of March 2017
Source: CME group as of 2 March 2017
Interestingly, these more hawkish comments appear to have hardly impressed equity markets. They paused after Yellen’s testimony and after the publication of the minutes, but nothing more than that. Perhaps markets see this news as confirmation of the reflation trade and believe that the traditionally positive correlation between equities and the fed funds rate early in the tightening cycle will still hold.
The unresponsiveness of government bond yields also helped steady equities, of course. But why did yields not react? Are investors more worried that the economy will not be able to cope with higher rates? This could be the case: banks have recently been more cautious on making business and consumer loans. Loan growth has eased accordinly.
Written on 2 March 2017