Posted by on March 15, 2017 3:26 pm
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Categories: Banking BLS Business CPI Economy Excess Reserves FED Federal Open Market Committee Federal Reserve System Financial economics Greenspan put Interest rates Janet Yellen Macroeconomics Monetary Policy money Recession Senate committee Trump Administration unemployment US central bank US Federal Reserve

While it is now virtually assured (odds are 95% according to the CME) that the Fed will announce a 25 bps rate hike today following an unprecedented attempt to reprice the Fed Funds market over the past month by Fed speakers – recall that as recently as three weeks ago, nobody expected a March move by the FOMC – what traders and analysts will be focused on today are hints for the future of the Fed’s rate hike moves. Indeed, the Fed’s “dot plot” will come under intense scrutiny after the BLS earlier today confirmed that the Fed may be well behind the curve when it comes to rising prices, after headline CPI printed at a blistering 2.7%, the highest rate in 5 years, with even the tamer core inflation rising 2.2%, above the Fed’s target of 2.0%.

A comarable reading by real-world prices as calculated by PriceStats showed that inflation in the US is now soaring at an annual rate of 3.6%, nearly double the Fed’s core target.

As such, the focus will fall upon the dot-plot and Yellen presser – in particular any updates that indicate a steeper rate hike path and whether the long-run policy rate target rises above 3%. According to many analysts the key variable for the market’s tone over the next few weeks will be not so much what the average 2018 dot is, but whether and where the Fed puts its median “long-term” dot: at, or above 3%. Given the Fed waited a year between hikes when moving away from the ZIRP era, this decision is seen as an indicator for whether a new era is upon us, one in which three or four hikes per year is the new norm. A further reason why the Fed is eager to hike rates is so it has “wiggle room” on interest rates for when stock markets inevitably see a correction and in advance of the next economic recession.

Recent data releases continue to support the path forward towards ‘normalization’ and the accompanying statement is expected to validate the uptrend in the domestic economy, as the strength of US consumer spending and employment has led many to believe that the economy can absorb several hikes this year. The Fed, ironically, has the new Trump administration to thank for this environment – as the proposed fiscal stimulus, tax cuts and laxer regulations create slack elsewhere in the economy, and have boosted “animal spirits”, smoothing the Fed’s path for tightening.

While some have speculated that much of what has been proposed by the new government will not come to pass, but the Fed cannot run the risk of getting too far behind the curve. As noted above, most inflation metrics are now running at or above the Fed’s mandated 2% Y/Y, bar the favoured PCE adjusted and core – given stocks near ATHs, and house prices nearing pre-2007 levels, the Fed will be aware that falling too far behind the curve may force them to steepen the hike path suddenly, potentially causing a crash for both stock and housing markets.

Therefore, the Fed is unlikely to indicate a steeper path in the immediate term, and instead the focus will be on the longer term forecasts, in particular if the long-run policy rate target rises above 3%.

Much like in the Funds Rate, the Fed will seek wriggle room with its bloated balance sheet and the current unprecedented level of $4.5Trillion (Including $2Tn MBS) would be compounded considerably if interest rates were near the longer term projection level (around 3%). For example, the interest paid to banks by the Fed on excess reserves in 2014 was USD 6.7Bn, with interest rates at 3.0% this would be more like USD 85Bn a very different, potentially politically sensitive, issue. In recent weeks we have seen that talk of balance sheet reduction has led to curve steepening, this was highlighted by Fed’s Bullard who noted that current reinvestment policy has placed upward pressure on the short end and placed downward pressure on other portions of the curve. The Jan/Feb minutes showed that the Fed agreed to begin discussion vis-à-vis balance sheet reduction at this meeting, therefore if there is no further clarity in the accompanying statement, expect it to be a key issue at the Yellen presser.

Another potential topic is the recent sharp drop in the price of oil, and whether the Fed will view this as a dovish signal – driven by weak demand – or see through it and attribute it to ongoing supply imbalances.

With that said, here are five main things to look for in today’s statement and Yellen press conference:

  • Rate Increase

It would now be a significant shock if the US central bank did not lift the target range for the federal funds rate by another quarter point from the current 0.5 per cent to 0.75%. The chances of a move were seen by markets at around 95% going into the meeting. So the issue for investors is judging whether the next move could come as soon as June and whether there is the possibility of four increases this year, rather than the three predicted in December. Either way, the Fed is still likely to characterise its rate-raising plans as “gradual”.

  • The Fed’s Views On The Economy

The post-meeting statement will reaffirm the continued strengthening of the jobs market and moderate growth in the overall economy. It may acknowledge that the headline measure of inflation tracked by the COM is now at 1.9% year on year, just a notch below the Fed’s target, although core inflation still remains a little further behind. A key question is whether there will be any further change to language on the risks of positive or negative developments hitting the economy. Right now, the risks are seen as ”roughly balanced”, pointing to a fair degree of sangfroid.

  • Fed Forecasts

The Fed will update growth, inflation and unemployment forecasts last released in November. Crucially, it will also produce a dot-plot showing individual policymakers’ predictions for the federal funds rate. As of December the median prediction was for three increases in 2017, but if four or more officials lift their outlooks to four increases it would be enough to shift the median up a notch. Janet Yellen, the Fed chair, signalled in her most recent speech that she was comfortable with the three-increase forecast released in December. In a tweak to gratify central banking aficionados, the Fed has said it will add so-called fan charts to its economic projections illustrating the uncertainty around those forecasts. These will appear with minutes to this week’s meeting released on April 5.

  • The Fate Of The Fed’s Balance Sheet

The Fed’s balance sheet has swollen to $4.5tn via its crisis-era interventions, which included purchases of vast quantities of government bonds and mortgage-backed securities. Officials have started openly discussing the possibility of reducing the size of its holdings. The Fed seems likely to retain existing language in its statement pledging to keep reinvesting the proceeds of maturing securities in its portfolio until normalisation of rates is “well under way”. However, Yellen is likely to face questions in a post-meeting press conference starting at 2.30pm EDT about when and how the Fed could start shrinking its balance sheet. How she handles those questions is very market sensitive. The Fed in 2013 managed to discombobulate financial markets with a miscued signal regarding its balance sheet strategy.

  • The Impact of Trump

The unspoken elephant in the room is what Trump’s fiscal policies could do to both the Fed’s forecasts. The problem is that there is still very little clarity on either composition, timing or implementation. As such, the FOMC is flying blind when it comes to Trump’s fiscal policies which many have speculated could quicken inflation as a result of the modest slack in the economy, forcing the Fed to tighten financial conditions even more, and pushing short-term rates even higher, faster to keep inflation in check. This too is a topic that will be certainly touched upon during the Yellen press conference.

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Market Reaction

Given a hike is essentially fully priced, language accompanying the decision will be under the spotlight, as participants will be attempting to gauge just how much of a ‘bullish hike’ this is. Most analysts expect the Fed to reiterate its commitment to ‘gradual rate hikes’. As such, the median Fed Fund Rate projections are likely to remain the same in the shorter term, with the longer term under intense scrutiny. If it is held at 3% this could be viewed as dovish (more so, if one or more of the shorter term projections is moved slightly lower) — If raised above 3% this could be seen as a hawkish hike (more so, if one or more of the shorter term projections is moved slightly higher).

If the Fed move, it will be only the third hike away from ZIRP, but will break with a precedent of waiting a year between hikes. Many analysts have speculated that if participants begin to believe that three or four hikes a year is the new norm it could puncture the current euphoria in US stocks. The more bullish the hike – the more the ‘three or four hikes a year’ narrative will take hold, meaning a more pronounced move away from stocks – although how quickly this will happen is open to a great deal of speculation, as hikes in recent times have been indicative of economic optimism and potentially bullish for stocks. Furthermore, rates at 0.75-1.0% is still well below the March Y/Y change in core PCE, meaning the inflation adjusted Fund Rate will remain negative whatever occurs at this meeting. So it could be a while yet before higher rates affect the bullish sentiment in stocks.

It is most likely that at this meeting a neutral position will be taken in regards to the balance sheet, i.e. that reducing the balance sheet has been discussed but more consideration is needed. A hawkish view from Yellen could be along the lines of ‘shrinking the balance sheet may be deliberated later this year’ — potentially causing the curve to steepen. A dovish tone would be ‘will not be under consideration until next year’ — likely meaning a flatter curve.

In relation to fiscal stimulus, Yellen has said “We are not basing our judgments about current interest rates on speculation” and although other Fed members have given the new fiscal atmosphere greater recognition, Yellen is unlikely to veer from comments made before the Senate Committee in February. A stand-pat approach where this is concerned is very much expected (given it is yet to materialize in law, let alone in the economy) however, if she pushes the line of fed policy independence’ it may well be viewed as hawkish.

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