FOMC Review: The doves are back in town?

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1 In Focus: US Fed Treasury Research Group For private circulation only FOMC Review: The doves are back in town? Chart 1: FOMC s Economic Projections The Fed hiked the target range for the federal funds rate by 25 bps on expected lines. The dot plot was lowered for 2019 to show only a cumulative 50 bps hike against previous expectations of 75 bps hike with another 25 bps rate hike expected in However, the underlying message provided by the Federal Reserve was dovish with an increase in emphasis that future actions are expected to remain data dependent. US yields softened particularly at the longer-end as investors got confirmation of a shallower rate hiking cycle that resulted in a further flattening of the US sovereign yield curve. We see this trend persisting in the near-term. The Fed expressing concerns about the health of the global economy resulted in risk aversion that in turn kept the USD bid. Fed meets market expectations Source: Fed, ICICI Bank Research Shivom Chakravarti shivom.chakravarti@icicibank.com Tel no: Ashray Ohri ashray.ohri@icicibank.com Tel no: December 20 th, 2018 Please see important disclaimer at the end of this report The FOMC delivered a 25 bps rate hike in its target range for the federal funds rate to the 2.25%-2.50% mark that was on expected lines. The dot plots were lowered across the years with the Fed projecting 2 more hikes for 2019 as opposed to three hikes earlier followed by one rate hike in 2020 and status quo in The median long-run rate was also lowered by 25 bps to 2.75% against 3% in the previous occasion that the forecasts were released in Septemebr To justify these revisions, the Fed lowered its growth and inflation projections (see chart 1) for 2018 and 2019 respectively while unemployment rate projections were increased for 2020 and 2021 respectively. Some important take-aways are: (a) The only major change in the policy statement was the references that were made to risks to the economic outlook. While the risks were continued to described as being balanced, there was a new line inserted alongside these risks to state that the committee will continue to monitor global economic and financial developments and assess their implications for the economic outlook. In short, the Fed is more concerned about the effect that slowing global growth momentum and tightening financial conditions will have on the outlook rather than being overly concerned about local US developments. (b) In the press conference, the Fed Chair laid great emphasis on future actions being more data dependent than was the case previously. He stated that there was a high degree of uncertainty about the path of rates. These statements presumable have to do with the lack of an acceleration in US inflation pressures. (c) The Fed chair offered little clarity on the neutral rate and accorded a high degree of uncertainty around it. (d) The Federal Reserve also emphasized that it expects to continue with the pace of its balance sheet tapering of USD 50 bn per month and that a further acceleration or an explicit medium-term target for the balance sheet was not on the cards. (e) The combination of changes made on the economic projections were viewed by the market to be on the dovish side.

2 Monetary policy expectations: Even as US growth prospects still remain fairly robust in the near-term, we believe that the FOMC s decision to turn dovish has to do with the fact that inflation is not accelerating and that the risks to the outlook have increased from exogenous developments and tightening financial conditions. The Fed Chair explicitly indicating that with the current rate hike the the FOMC has reached the bottom end of range of the committees estimates for the neutral rate implies that the rate hiking cycle will be shallower than previously assumed. However, given that labour markets are still robust and GDP growth is forecasted to be above trend level in 2019 at aggregate, we continue to expect 50 bps worth of rate hikes over 2019 with the Fed likely to end its rate hiking cycle. The Fed could deliver a series of two dovish rate hikes in 2019 especially if inflation continues to undershoot the Fed s expectations. Market implications: Although the Federal Reserve delivered a dovish rate hike as was being priced in by the markets, the tone particularly in the press conference stoked concerns about medium-term growth prospects both in the US economy and in the global economy. The explicit references on concerns about global growth prospects and financial market conditions was followed by the Federal Reserve Chairman emphasizing a more data dependent tone going forward. With US inflation pressures not showing signs of accelerating he gave an impression that there is a higher bar to hiking rates going forward in 2019 than was the case in Hence, the net result has been markets pricing in a shallower rate hiking trajectory that resulted in a further flattening in the UST 10 yr and UST 2 yr spread from 17 bps in yesterday s trading session 13 bps at the time of writing. We expect this flattening to inversion bias across different tenors in the sovereign yield and swap yield markets to continue in the near-term as the US fixed income markets grapple with a lower Fed terminal rate than was the case just a month back. As long as inflation does not accelerate sharply, we expect this trend to sustain. We see a further downside potential in the UST 10 yr and lower our projections to a near-term trading range of 2.70%-2.80%. The story in the FX markets was a bit different. First, the Fed emphasized that the main source of risk to the US growth outlook could come from global developments. This in turn resulted in a hefty bout of risk aversion pulling US and global equity markets lower. Inadvertently the Fed s concerns about the global economy triggered safe-haven buying that pushed the DXY higher in the process. While we would not rule out further possible upside, we reiterate our bearish USD call over the medium-term given that we expect the growth divergence between the US and non-us world to shrink. Chart 2: Federal Reserve dot plot from December 2018 policy Source: Federal Reserve, ICICI Bank Research 2

3 FOMC statement comparison November 8th, 2018 December 20th, 2018 Our assessment Growth The labor market has continued to strengthen and that economic activity has been rising at a strong rate. The labor market has continued to strengthen and that economic activity has been rising at a strong rate. Labour market Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low Other sectors Household spending has continued to grow strongly while business fixed investment has moderated from its rapid pace earlier in the year Household spending has continued to grow strongly while business fixed investment has moderated from its rapid pace earlier in the year Inflation On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance. Risk to the outlook The Committee expects that further gradual increases in the target range for the federal funds The Committee expects that further gradual rate will be consistent with sustained expansion of increases in the target range for the federal funds economic activity, strong labor market conditions, rate will be consistent with sustained expansion of and inflation near the Committee s symmetric 2 economic activity, strong labor market conditions, percent objective over the medium term. Risks to the and inflation near the Committee s symmetric 2 economic outlook appear roughly balanced, but percent objective over the medium term. Risks to the will continue to monitor global economic and economic outlook appear roughly balanced. financial developments and assess their implications for the economic outlook dovish On Fed funds rate In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2 to 2-1/4 percent. In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2-1/4 to 2-1/2 percent. Voting Voting for the FOMC monetary policy action were: Jerome H. Powell, Chairman; John C. Williams, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Richard H. Clarida; Mary C. Daly; Loretta J. Mester; and Randal K. Quarles. Voting for the FOMC monetary policy action were: Jerome H. Powell, Chairman; John C. Williams, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Michelle W. Bowman; Lael Brainard; Richard H. Clarida; Mary C. Daly; Loretta J. Mester; and Randal K. Quarles. 3

4 ICICI Bank: ICICI Bank Towers, Bandra Kurla Complex, Mumbai Phone: (+91-22) Treasury Research Group Economics Research Kamalika Das Economist (+91-22) (ext 6280) Shivom Economist (+91-22) (ext 6273) Chakravarti Anushri Bansal Economist (+91-22) (ext 6220) Sumedha Economist (+91-22) (ext. 7243) Dasgupta Ashray Ohri Economist (+91-22) (ext. 7249) Pradeep Kumar Economist (+91-22) (ext. 6272) Yash Panjrath Economist (+91-22) (ext. 8161) Sparsh Chhabra Economist (+91-22) (ext. 7309) Treasury Desks Treasury Sales (+91-22) Currency Desk (+91-22) Gsec Desk (+91-22) FX Derivatives (+91-22) /43 Interest Rate Derivatives (+91-22) Commodities Desk (+91-22) Corporate Bonds (+91-22)

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