US Fed: More hawkish than expected

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1 Policy Watch: US Fed Treasury Research Group For private circulation only US Fed: More hawkish than expected Chart 1: Median FFR projection increased for 2018 and 2019 The Fed hiking rates was on expected lines. However, the upward shift in the dot plot came somewhat earlier than we had anticipated. We view the policy statement, revisions to economic projections and the post policy conference on aggregate as coming in more on the hawkish side than we anticipated. We revise our expectations of two more cumulative rate hikes in The USD could benefit from a hawkish Fed but we continue to watch US protectionist push carefully. The US yield curve is likely to move higher but the shape is likely to remain unchanged. Fed turns more hawkish than expected: The increase in the Federal funds target range to 1.75%-2.00% was widely expected. However, the policy statement along with projections came in more on hawkish side that what we had anticipated. While we expected a rate hike, we believed that a change in the quantum of rate hikes as expressed in the dot plot would come later on in the year. Source: Federal Reserve and ICICI Bank Research June 13, 2018 Shivom Chakravarti shivom.chakravarti@icicibank.com Tel no: Ramakrishna Reddy Bogathi ramakrishna.bogathi@icicibank.co m Tel no: Please see important disclaimer at the end of this report However, as we have emphasized in our preview that the threshold for such a change was low given that only one additional member was required to favour an additional rate hike and most Fed officials have been sending hawkish messages. Nevertheless, the changes made in the projections along with our expectations that the fiscal stimulus will likely work its way to ensure that the output gap remains positive that would in turn maintain an upside bias on inflation is likely to result in the Fed hiking rates by another 50 bps over the remainder of The decision to alter the rate hiking pattern over from to was justified by the increases in the inflation projections and evidence of more robust growth. Changes in tone: There were some important changes that perhaps provide indications of a hawkish tone : Economic activity was described as being solid compared to moderate in the previous meet. This change was presumably done to reflect the impact of the fiscal stimulus driving growth higher. There was a removal of the guidance that the fed funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer-term. This change was done to take into account of the fact that the policy rate is gradually moving towards its neutral rate as the US macroeconomic landscape has improved. The statement that market-based measures of inflation compensation remain low was removed highlighting the recent uptick in break-even inflation rates. Although the Fed s balance sheet reduction has come in for some criticism in recent weeks by EM central banks, the Fed confirmed that it will press on regardless and step up the pace of balance sheet run-off in July as previously planned. Key takeaways from the Powell s press conference Jerome Powell s conference was relatively less hawkish than the statement as he highlighted that the removal of forward guidance and changes in the dot plot does not indicate faster rate hikes rather they reflect underlying changes in the economy. He further added that the gradual rate hike path of the fed will continue.

2 Policy Watch Chart 2: Unemployment rate revised further lower Median Fed macro-economic projections Long term GDP (%YoY) Mar Jun Unemployment Rate (%) Mar Jun PCE inflation (%YoY) Mar Jun Core PCE inflation (%YoY) Mar n.a. Jun n.a. Median Fed funds rate (%) Mar Jun Source: Federal Reserve and ICICI Bank Research The main takeaways from his conference are the following: Fiscal policy will provide significant support to the demand over the next 3 years. Risks are rising due to uncertainty in the trade policy but economic data is yet to reflect any impact The flatness in the yield curve is not a concern and it s expected because of the rate hikes. Rates are expected to be neutral soon assuming we stay on this path of gradual rate rises. On slower wage growth, Powell said it is bit of a puzzle considering the tightness in the labour market and lower unemployment rates. On natural rate of unemployment rate, he added that it is difficult to estimate due to changing composition of the education levels among the workforce. Overall, today s policy statement and the press conference indicate that the Powell s Fed has taken a definite shift towards hawkish side as compared to the Janet Yellen s Fed. Unemployment rate revised further lower In its quarterly Summary of Economic Projections (SEP), Fed revised unemployment rate lower after the recent data singled further tightness in the labour market while inflation and growth were revised marginally higher. Growth projections for 2018 were revised up from 2.7% to 2.8% while the projections for 2019 and 2020 were kept at 2.4% and 2.0% respectively. The unemployment rate was lowered across the period from 3.8% to 3.6% for 2018, from 3.6% to 3.5% in 2019 and from 3.6% to 3.5% in PCE inflation was revised higher from 1.9% to 2.1% for 2018, from 2% to 2.1% for 2019, and kept unchanged at 2.1% for Core PCE inflation was revised up from 1.9% to 2% in 2018 but kept unchanged at 2.1% for both 2019 and Market implications: The USD is expected to remain in demand as divergence in monetary policy stances between the US and at least the G-10 world get reemphasized again from a hawkish Federal Reserve. Besides, US real policy rates are likely to turn positive by the end of the year that could in turn create further support for the USD. We in particular take note of the fact that European data flow does not show broad-based signs of recovering that in turn is likely to add to the USD s appeal in the nearterm. However, the favourable USD trading environment from a monetary policy and business cycle perspective needs to be also counter-balanced by the US government s protectionist push that works as a negative for the USD. The net result of the tussle between these two forces is likely to mean more volatility in the FX markets and in turn limit the upside potential in the USD. While US yields moved higher across the curve, the yield curve flattened as yields at the shorter-end moved higher at a faster pace responding to the revisions made to 2018 rate projections. We continue to expect US sovereign yields to move higher with the shape of the yield curve likely to remain unchanged. 2

3 A. FOMC statement comparison Growth Annexure Policy Watch FOMC statement comparison May 2nd, 2018 June 13th, 2018 Our assessment The labor market has continued to strengthen and that economic activity has been rising at a moderate rate. The labor market has continued to strengthen and that economic activity has been rising at a solid rate. Hawkish Labour market Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Mildly hawkish Other sectors Recent data suggest that growth of household spending moderated from its strong fourth-quarter pace, while business fixed investment continued to grow strongly. Recent data suggest that growth of household spending has picked up, while business fixed investment has continued to grow strongly. Hawkish Inflation On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent. Market-based measures of inflation compensation remain low; survey-based measures 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 have moved close to 2 percent. Indicators of longer-term inflation expectations are little changed, on balance. Mildly hawkish Risk to the outlook The Committee expects that, with further gradual The Committee expects that further gradual increases adjustments in the stance of monetary policy, in the target range for the federal funds rate will be economic activity will expand at a moderate pace in consistent with sustained expansion of economic the medium term and labor market conditions will activity, strong labor market conditions, and inflation remain strong. Inflation on a 12-month basis is near the Committee's symmetric 2 percent objective expected to run near the Committee s symmetric 2 over the medium term. Risks to the economic outlook percent objective over the medium term. Risks to the appear roughly balanced. economic outlook appear roughly balanced. neutral 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 1-1/2 to 1-3/4 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. 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 1-3/4 to 2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. neutral Voting Voting for the FOMC monetary policy action were Jerome H. Powell, Chairman; William C. Dudley, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Loretta J. Mester; Randal K. Quarles; and John C. Williams. Voting for the FOMC monetary policy action were Jerome H. Powell, Chairman; William C. Dudley, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Loretta J. Mester; Randal K. Quarles; and John C. Williams. *Highlighted portions represent additions to the statement 3

4 B. Comparison of dot-plots on Fed funds rate projections March Dot-plot June Dot-plot Policy Watch Note: In the panel above, each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. C. Basic Definitions Fed funds rate The interest rate at which banks and other depository institutions trade balances (held at the Federal Reserve) with each other, usually on an overnight basis. The Fed fund rate target range reflects the band that the Federal Reserve intends to move the federal funds rate into. This Fed funds target range currently stands at 1.75%-2.00%. The weighted average rate for all of these types of transactions is called the effective Federal funds rate. D. Details of Normalisation tools being used by the Fed Interest on excess reserves (IOER) Prior to the financial crisis, reserve balances at the Federal Reserve did not earn interest. However, legislation passed in 2006 and 2008 authorized the Federal Reserve to pay interest on reserves held by depository institutions, starting in October FOMC participants voted, in this meeting, to raise the interest rate paid on required and excess reserve balances (IOER) to 1.95%. Overnight Reverse Repurchase Agreement Facility (ON RRP) IOER is not available to many large and active money market investors, such as money market funds (MMFs), other cash-management vehicles, nonfinancial corporations, and government-sponsored enterprises (GSEs). In some respects, an ON RRP facility would operate similar to the way the Federal Reserve's payment of interest on excess reserves works for depository institutions. In general, any counterparty that is eligible to participate in the ON RRP facility should be unwilling to invest funds overnight with another counterparty at a rate below the ON RRP rate. The Board of Governors, in today s policy decision, authorised the use of overnight reverse repurchase facility (ON RRP) and set the offering rate at 0.75% (prior: 0.5%). Discount rate The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. Under the primary credit program, loans are extended for a very short term (usually overnight) to depository institutions in generally sound financial condition. Depository institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities. 4

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