FOMC Preview, by Tim Duy: The Fed will take a pass at this week’s FOMC meeting. The median policy participant forecasts just three 25bp rate hikes this year and incoming data offers no surprises to force one of those this month. March, however, remains in play.
The three forecasted rate hikes is not a promise. It could be one hike or could be four or more. The actual outcome will depend on the path of actual economic outcomes and what those outcomes imply for the forecast.
The Fed is aware that crosscurrents in the economy – such as potentially significant changes to fiscal and economic policy – create substantial uncertainties about the course of monetary policy this year. From the most recent minutes:
…many participants emphasized that the greater uncertainty about these policies made it more challenging to communicate to the public about the likely path of the federal funds rate.
Translation: The Fed’s crystal ball is as cloudy as everyone else’s, but that’s hard to explain. For example, the potential positive demand shock from expected deficit spending could be overwhelmed by a potential negative supply shock from an increasingly xenophobic Trump Administration.
What does this mean for March? Currently, market participants place low odds of a March rate hike. The underlying bet is that if the Fed moves three times this year, the most likely timing will be June, September, and December. I think this is reasonable; bringing March into that mix requires a change in the tone of the data.
Specifically, to pull a rate hike forward, the Fed needs evidence that either inflation is firming more than anticipated or that unemployment is more significantly undershooting its natural rate. Both would be cause for concern for policymakers. But, in practice, given the inflation inertia evident in recent years, the labor market would most likely be the driving force of behind a March rate hike. From the minutes:
Several members noted that if the labor market appeared to be tightening significantly more than expected, it might become necessary to adjust the Committee's communications about the expected path of the federal funds rate, consistent with the possibility that a less gradual pace of increases could become appropriate.
The December labor report was largely consistent with the Fed’s forecasts, and thus will have little impact on the March meeting. The same is true for the GDP report for the final quarter of 2016. Notable is that domestic demand has held up well the last three quarters:
They will also be heartened that equipment investment, broke a string of four consecutive negative quarters with a 3.1 percent gain. Also, note that core durable goods orders are finally back to making year over year gains:
This too is consistent with the small uptick in growth anticipated by the Fed for 2017.But we still have plenty of data between now and March. In particular, watch incoming data and how they impact the forecast of key variables such as unemployment and inflation. The Fed will pay close attention to:
- Nonfarm payrolls. They expect payroll growth to continue slowing to something close to 100k a month. A re-acceleration would raise eyebrows on Constitution Ave.
- The unemployment rate. The Fed’s estimate of the natural rate of unemployment firmed over the past year. Hesitation to drop it lower means that surprise falls in unemployment would prompt more aggressive Fed action.
- Faster wage growth. Some policy makers argued in December that subdued wage growth gave them more time to respond to an unemployment overshoot. But wage growth accelerated in December to 2.9% annually, the highest pace since 2009. Watch this space (and see this from Bloomberg on competition for workers in the fast food industry).
- Inflation numbers. Although, as noted earlier, inflation has been fairly inertial, that could change at the economy settles further into full employment/potential output.
- Acceleration? The Fed is not anticipating a large acceleration in activity this year, so any indication that activity is picking up more than expected will be watched with wary eyes.
At this point I still do not anticipate a March hike. And note that a March move doesn’t guarantee a faster pace of rate hikes; it could be largely pre-emptive, just displacing a subsequent rate hike. But if they could justify a March move and you were anticipating two to three rate hikes this year, you should probably be thinking of three to four. Not to mention some action on the balance sheet added to the mix.