US FOMC preview: Fed to recommence monetary tightening cycle

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1 In Focus: Occasional Treasury Research Group For private circulation only Sumedha DasGupta December 13, 2016 Please see important disclaimer at the end of the report US FOMC preview: Fed to recommence monetary tightening cycle The Federal Reserve is raise the Federal Funds rate by 25 bps from the target range of 0.25%-0.50% Policy statement will be closely watched for cues on hike trajectory. Contingent on incoming data prints, we maintain our view of an increased pace of tightening in the US, especially if the new regime provides adequate fiscal stimuli. The US Federal Reserve will conclude its two-day monetary policy meeting on December 14 th, Fed to hike the Fed Funds Rate The Federal Reserve is hike the target range for the Fed Funds rate (0.25%-0.50%) by 25 bps. With overall data prints since the Fed s last meeting in November being broadly on the positive side, the Fed is tighten monetary policy in anticipation of strong fundamentals underpinning economic growth in the US. Additionally, with indications of an increasingly tight labour market, the Fed will move on rates to avoid falling behind the curve. In light of the second rate move after the financial crisis being imminent, it is worthwhile to take a look at the past year and examine the long pause taken by the Fed. Moderate economic improvement engendered the rate hike in December 2015 Commencing its tightening cycle after a span of over nine years, the Federal Reserve hiked the Fed Funds rate by 25 bps in December 2015, bringing the target range to %. At this policy meet, the Fed noted that: Economic activity had been expanding at a moderate pace. Favourable labour market indicators including continuing job gains and declining unemployment rate. Household spending and business had been increasing at solid rates. Housing sector had shown further improvement. Risks to economic activity and labour market were seen as balanced. Expectation of a rise in inflation to the 2% target of the Committee in the medium term The policy cited that incoming data on labour market condition, inflation and global financial developments would be key in guiding rate moves ahead. The median projection of the Fed Funds rate had then projected three-four rate hikes to be in the offing in However, the year has almost elapsed with no rate hikes undertaken yet As we look back on the year, it is clear that the Fed was unable to raise its policy rate in all seven of its past meetings in While geopolitical pressures such as Brexit, and domestic uncertainties such as the US Presidential elections kept expectations volatile, the Fed s own commentary lends important cues on reasons for remaining on hold for nearly the entire year. Fed commentary in its past meetings in 2016: 28 th Jan 16 th Mar 27 th Apr 15 th Jun 27 th Jul 21 st Sep 2 nd Nov Growth Labour market Other sectors Economic growth slowed towards the end of Growth in economic activity appears to have slowed Pace of improvement in the labour market has slowed. Job gains have diminished. Household spending and business increasing at a moderate rate. and net exports have been soft Growth in household spending has moderated. and net exports have been has been -- Unemployme nt rate is little changed in recent months. has been has remained Unemployme nt rate is little changed in recent months. has remained

2 Inflation Risks to outlook 28 th Jan 16 th Mar 27 th Apr 15 th Jun 27 th Jul 21 st Sep 2 nd Nov Inflation has Inflation has Inflation has Inflation has Inflation has Inflation has Inflation is still continued to continued to continued to continued to continued to continued to below the run below the run below the run below the run below the run below the run below the FOMC s 2% FOMC s 2% FOMC s 2% FOMC s 2% FOMC s 2% FOMC s 2% FOMC s 2% longer-run longer-run longer-run longer-run longer-run longer-run longer-run objective. objective. objective. objective. objective. objective. objective. Market based Market based Market based Market based Market based Market based Market based measures of measures of measures of measures of measures of measures of measures of inflation inflation inflation inflation inflation inflation inflation compensation compensation compensation compensation compensation compensation compensation have moved declined remain low. remain low. declined. remain low. remain low. up, but further. remain low. Inflation remain low in the near term. The Committee is closely monitoring global economic and financial developments and assessing their implications for the labour market and inflation and balance of risks to the outlook Global economic and financial developments continue to pose risks. Inflation remain low in the near term The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in funds rate; funds rate is likely to remain, for some time, below levels that are prevail in the longer run. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in funds rate; funds rate is likely to remain, for some time, below levels that are prevail in the longer run. -- As we approach the last policy meet of 2016, expectations are strong of a rate hike finally materialising The upcoming Fed meeting this week appears to be different from the past ones this year in three significant ways: 1> Fed Chair, Janet Yellen s commentary: In her testimony to the Joint Economic Committee of the US Congress in November, Fed Chair Janet Yellen said that the American economy was making very good progress towards the Fed s goals. Yellen noted that at the November FOMC meeting, the Committee had judged that the case for an increase in the target range had continued to strengthen and that such an increase could well become appropriate relatively soon if incoming data provide some further evidence of continued progress toward the Committee's objectives. She also cited the dangers of waiting too long, which could result in the Fed having to move too quickly in the future. 2> Indications of increasingly hawkish commentary at Fed meetings in the recent months: In September 2016, the FOMC was seen saying: The labour market has continued to strengthen and growth of economic activity has picked up from the modest pace seen in the first half of this year. Job gains have been solid, on average. This was followed by a more hawkish tone in the November 2016 FOMC meet: The case for an increase in the Federal Funds rate has continued to strengthen. Inflation has increased somewhat since earlier this year. Market based measures of inflation compensation have moved up. 3> Economic scenario largely healthy The US economy has shown a healthy pace of recovery in recent months. GDP growth for Q printed at an eight-quarter high 3.2% QoQ (ann.), with a strong turnaround in inventory and exports. On the inflation front, PCE inflation (the Fed s preferred inflation gauge) saw an uptick to 1.4% YoY in October 2

3 from 1.2% YoY in the previous month, while core PCE remained sticky at 1.7% YoY. CPI inflation also rose to a two-year high of 1.6% YoY in October, picking up from 1.5% YoY in September. Nonfarm payrolls rose by 178K in November, picking up from a modest 142K in October, with the unemployment rate dipping to 4.6%. Consumer confidence edged up to a nine-year high in November from earlier. Manufacturing data prints (ISM, PMI, Dallas Fed) have also been painting an incrementally positive picture. In light of these reasons, the December 2016 meet of the Fed will occur in markedly better circumstances than seen throughout this year. Additionally, geopolitical uncertainties surrounding the Brexit referendum have diminished, while OPEC has come to a stable decision, and the US Presidential elections are now behind us. Thus, the timing would be optimal for a rate hike move by the Fed. Expectations from the Fed policy: Markets have widely priced in expectations of a rate hike this week. Given the importance markets place on the Fed s commentary and its implications, in the absence of which, markets have been known to react with volatility, it is extremely unlikely for the Fed to thwart market expectations in the upcoming policy review. In the immediate aftermath of the policy, we are likely to see a moderate rise in the Dollar index (given that the rate hike is already factored in by markets), and a slight hardening in 2Y and 10Y US Treasury yields. Besides our rate hike expectation, focus will also be on the tone of the statement by the Fed Chair, Janet Yellen, especially in the backdrop of the fiscal boost plans of the new regime in the US. With tax cuts and a reduction in regulations on the anvil, the US will see a substantial spurt in capital inflows, lending strength to the Dollar, which is chart a sharply upward trend in Bond yields (both 2Y and 10Y) are continue rising in 2017 as the bond market selloff deepens with rising inflation expectations. Possible changes to watch for in the upcoming statement: Inflation: In its December 2015 policy statement, the Fed had stated that Inflation is rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipate. In the backdrop of the recent deal brokered by the OPEC and non-opec countries to pare crude oil production and shore up prices, energy prices are likely to move up going into With both headline and core PCE inflation on a steady upward trend in recent months, the Fed is likely to revise its inflation expectations for 2017 upward, especially on the back of higher energy prices. Labour market: In its December 2015 statement, the Fed had said A range of recent labour market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labour resources has diminished appreciably since early this year. The Fed is likely to state something similar this week, highlighting the recent reduction in the unemployment rate. Risks to economic outlook: The December 2015 statement mentioned Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labour market as balanced. In a key development, the upcoming statement should see the FOMC mentioning risks as balanced, rather than roughly balanced as it has multiple times this year. Dot plot: With inflation rise faster going ahead, the commentary is also likely to sound hawkish on the pace of rate increases. The Fed dot plot currently shows slow and calibrated rises going ahead (2 rate hikes in 2017 and 3 in 2018). However, we are likely to see an upward shift in the dot plot if the Fed commentary turns hawkish, which will be watched closely. 3

4 Annexure FOMC statement comparison: In comparison to the previous statement, we outline our expectations from the Fed commentary on the 14 th. The key driver for these expectations are improving labour market and inflation metrics. Growth Labour market Other sectors Inflation Risks to the outlook On the Fed Funds rate 2 nd November th December 2016 The labour market has continued to Likely to be similar in light of robust GDP strengthen and growth of economic activity data for Q has picked up from the modest pace seen in the first half of this year. Although the unemployment rate is little changed in recent months, job gains have been solid. Household spending has been rising moderately but business has remained Inflation has increased somewhat since earlier this year but is still below the Committee s 2% longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Marketbased measures of inflation compensation have moved up but remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months. Inflation is rise to 2% over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labour market strengthens further. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments. The case for an increase in the Federal Funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress Likely to cite the improvement in the unemployment rate, and re-emphasize solid job gains in light of healthy nonfarm payrolls data. Likely to sound similar. Likely to continue to recognize the pickup in PCE inflation in recent months. The Fed is may revise its median inflation projections upward for Likely to mention near-term risks to the economic outlook as balanced. May cite a faster pace of rise in inflation on the back of expected stimulus from the incoming government. May also highlight financial risks in light of President-elect Trump s desire to soften the regulatory regime in the US. Likely to shed light on the broad further trajectory of increase in funds rate in The dot plot is likely to show an upward shift indicating a faster pace of rate hikes in ICICI Bank: ICICI Bank Towers, Bandra Kurla Complex, Mumbai Phone: (+91-22)

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