US Federal Reserve: Feels like the first time

US Federal Reserve: Feels like the first time Economic research note 17 December 2015 The US Federal Reserve (the Fed) has, finally and unanimously, started the monetary policy normalisation process by raising the Fed Funds target rate by 25bp to 0.25%-0.5%. Fed Chair Yellen has noted that while economic growth has been moderate, the labour market has shown considerable improvement. Fed Chair Yellen has also emphasised that further rate hikes will be gradual, with this term used twice in the official statement and repeatedly in the Chair s press conference. The Fed s dot forecasts for the Fed Funds rate have not been altered, with the end 2016 dot implying four rate hikes in 2016. We continue to expect three rate hikes in 2016, three in 2017 and a peak of 2.5% in 2018. This would be consistent with the Fed s view that the neutral real rate is currently around zero and will rise only gradually over time. Financial markets are now priced for an interest rate path close to our view. The Fed s economic forecasts have been altered only a little. The unemployment rate is now forecast at 4.7% through 2016, 2017 and 2018. Economic growth is forecast at 2.4% in 2016, then moderating to 2.0% by 2018. Underlying inflation is expected to drift higher from 1.6% in 2016, 1.9% in 2017 and 2.0% in 2018. Belinda Allen Senior Analyst, Economic and Market Research Stephen Halmarick Head of Economic and Market Research James White Senior Analyst, Economic and Market Research US Federal Reserve: Feels like the first time The Federal Open Market Committee (FOMC) of the US Federal Reserve (the Fed) has, finally and unanimously, started the monetary policy normalisation process by announcing a 25bp increase in the Fed Funds target range from 0%-0.25% to 0.25%-0.5%. This increase will, operationally, be achieved by lifting the Interest on Excess Reserves (IOER) from 0.25% to 0.50% and the Reverse Repo program rate from 0.05% to 0.25%. Both of these new rates will be effective as at 17 December 2015 in US markets. Full details of these operational matters are below. The statement accompanying the policy decision highlighted the improvement in the US economy, noting that there has been considerable improvement in labour market conditions this year. Overall, however, the Fed notes that economic activity has been expanding at a moderate pace, with household and business investment increasing at solid rates, housing improving further, but net exports soft. As widely expected, the Fed emphasised (twice) that the pace of further rate hikes will be gradual, stating that the Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the Federal Funds rate and that the Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labour market indicators will continue to strengthen. The Fed statement also reinforced the data-dependent nature of the policy outlook, stating that the actual path of the Federal Funds rate will depend on the economic outlook as informed by incoming data. However, although the Fed statement uses the word gradual twice, and Chair Yellen repeated this in her press conference, the Fed has not lowered their end 2016 dot plot estimate of the Fed Funds Rate, which remains at 1.4% (ie. a 1.25%-1.5% range) and implies four rate hikes in 2016. As detailed below, this is more aggressive than either priced into markets (two rate hikes) or our own forecasts (three rate hikes). 1

The communications challenge The communications challenge for Fed Chair Yellen and her colleagues will now be to signal to financial markets that the path forward for interest rates will be gradual, but is not pre-determined or mechanical and will be data-dependent, as well as financial markets dependent. In our view, the more important issue for markets than the fact the Fed has increased interest rates today will be the path forward and the end point. As stated, we continue to expect the Fed to increase interest rates only gradually, ie. three rate hikes in 2016, a further three moves in 2017 and then a peak of around 2.5% in 2018. For global financial markets, 2016 is expected to see further increases in volatility as a result of central bank activity. While the US Fed (and eventually the Bank of England as well) is expected to be putting interest rates up through 2016, other major central banks are expected to be easing policy further. This would include Europe, Japan and China. This central bank policy divergence is vastly different from the policy environment global markets have seen since the global financial crisis where all major central banks were essentially moving monetary policy in the same direction. So while the fact that the US Fed is putting interest rates up is a very positive sign for the US economy, it is likely to see an ongoing increase in market volatility through the year ahead. The path forward In a recent speech 1, and again today, Fed Chair Yellen implied that the current level of the neutral real Fed Funds rate was close to zero and that it is likely to rise only gradually over time. With core inflation now at 1.3%, this would imply a move in the Fed Funds target rate to a 1.0%-1.25% range by the end of 2016 ie. three more rate hikes in 2016 after today s move. At this point in time we expect the three Fed rate hikes to be in March, June and December 2016. The timing of these moves could vary depending on the data flow and market conditions. As the Core Personal Consumption Expenditures (PCE) Index trends higher, ie. if consistent with the Fed s own expectations, the Fed will then need to continue to adjust the Fed Funds target range through 2017-2018 to keep the real Fed Funds rate around zero, if not a bit higher. To achieve this objective we expect a further three rate hikes in 2017, ending the year at 1.75%-2%, and then a move to a peak around 2.5% in 2018, by which time the core inflation rate is expected to be at the Fed s price stability target of 2%. Chart 1 shows this expected path, compared with what the market now has priced in for the Fed and what the Fed s own dot forecasts (see below for details) would imply. The market does look to be closer to our expectations than those implied by the Fed dots. Chart 1: Projected path of US short rates and market expectations Source: Bloomberg. Data to 16 December. Lower and upper bound is the target range for the Fed Funds rate. Economic and Market Research team forecast as at 16 December 2015. In terms of the outlook for the Fed s balance sheet, the statement today noted that the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longerterm securities at sizable levels, should help maintain accommodative financial conditions. The dot plots: Having made the decision to raise the Fed Funds target range today, the key issue for markets now is the path forward for interest rates and the likely end point. In this regard the FOMC members dot point forecasts are important. For the end of 2015 the Fed Funds rate will now trade in the new 0.25%-0.5% range. As noted, at the end of 2016 the median dot is unchanged at 1.4% (1.25% - 1.5%), while the end 2017 median dot is now at 2.4% (2.25%-2.5%), from the September estimate of 2.6% (2.5% - 2.75%). The estimate of the end 2018 dot is also marginally lower at 3.3% (3.25%-3.5%), from 3.4% in the September estimate, while the long-term dot remains unchanged at 3.5%. Fed Rate median dot forecast Year end 2015 2016 2017 2018 Longterm Dec 15 0.4% 1.4% 2.4% 3.3% 3.5% Sept 15 0.4% 1.4% 2.6% 3.4% 3.5% June 15 0.63% 1.63% 2.88% N/A 3.75% March 15 0.63% 1.88% 3.13% N/A 3.75% Dec 14 1.13% 2.50% 3.63% N/A 3.75% Source: US Federal Reserve, 16 December 2015 1 The Economic Outlook and Monetary Policy, Janet L. Yellen, The Economic Club of Washington, December 2, 2015 2

The Fed s dual mandate: As we have noted previously, the Fed s monetary policy decisions are driven by the Fed s dual mandate: full employment and price stability. What is clear is that the full employment part of this mandate has all but been achieved with the unemployment rate down to 5% in November 2015, after peaking near 10% in December 2009. The Fed now expects the unemployment rate to decline to 4.7% in 2016 and remain at this level out to 2018. In terms of inflation, the Fed defines price stability as a headline inflation rate averaging near 2%. The current headline inflation rate is far from this at 0.5%/yr for November. However, the Core PCE (the Fed s favoured measure of inflation) is at 1.3%/yr in October, but is forecast by the Fed to rise steadily to 1.6% year-end 2016, 1.9% in 2017 and 2.0% in 2018. Chart 2 shows the progress on the Fed s dual mandate and the Fed s updated expectations. Chart 2: US Unemployment rate and Core PCE rate Actual and forecasts Source: Bloomberg and Federal Reserve. Unemployment rate as at 30 November 2015. Core PCE to 31 October 2015.Fed projections from December 2015 FOMC meeting. Revised Economic forecasts As per the usual quarterly pattern, the Fed has updated its economic forecasts. As detailed in the table below, the changes to the economic projections are relatively minor. On the labour market, the Fed now expects an unemployment rate of 4.7% at year-end 2016, 2017 and 2018 down marginally from the previous forecast of 4.8%. The longer-run unemployment rate forecast is unchanged at 4.9%. For 2016 the Fed now expects GDP growth of 2.4%, up a little from the September forecast of 2.4%. The 2017 growth forecast is unchanged at 2.2%, while the longer run forecast is unchanged at 2.0%. The inflation (Core PCE) forecast for 2016 as been revised marginally lower to 1.6% from 1.7%, but across the outyears the forecasts for inflation have all been held steady has shown in the table below. Economic median forecasts Dec and Sept 2015 FOMC forecasts (% change) 2015 2016 2017 2018 Longer run Real GDP 2.1 2.4 2.2 2.0 2.0 (Sept 15 f/c) 2.1 2.3 2.2 2.0 2.0 Unemployment rate 5.0 4.7 4.7 4.7 4.9 (Sept 15 f/c) 5.0 4.8 4.8 4.8 4.9 Core PCE inflation 1.3 1.6 1.9 2.0 2.0 (Sept 15 f/c) 1.4 1.7 1.9 2.0 2.0 Source: FOMC, as at 16 December 2015 How will the Fed raise interest rates? One of the key issues for market is not only the path forward for US interest rates but how, operationally, will the Fed actually raise interest rates. As we have stated previously, in the period prior to the Global Financial Crisis (GFC), the Fed would use the Federal Funds target rate as the major indicator of monetary policy. The Fed Funds rate is simply the interest rate at which banks borrow and lend from each other, usually overnight, to settle balances at the Federal Reserve. The market is dominated by banks regulated by the Federal Deposit Insurance Corporation (FDIC). However, the amount of borrowing and lending undertaken by FDIC regulated banks has fallen significantly since the GFC and the short-end of the US financial markets are now significantly less influenced by these institutions. To force short-term interest rates higher for the whole economy, not just the more narrow-based banking system, the Fed will now need to use other monetary policy tools. In an accompanying statement today the Fed has made it clear how they intend to achieve this objective. Raise the interest rate paid on required and excess reserve balances to 0.50 percent, effective December 17, 2015. Effective December 17, 2015, the FOMC directs the (NY Fed) Desk to undertake open market operations as necessary to maintain the federal funds rate in a target range of 1/4 to 1/2 percent, including: (1) overnight reverse repurchase operations (and reverse repurchase operations with maturities of more than one day when necessary to accommodate weekend, holiday, or similar trading conventions) at an offering rate of 0.25 percent, in amounts limited only by the value of Treasury securities held outright in the System Open Market Account that are available for such operations and by a per-counterparty limit of $US30 billion per day. Given that this is the first time the Fed has had to raise official interest rates through this mechanism, it could actually take a number of days/weeks before the effective 3

fed funds rate trades within the new 0.25%-0.5% target range. Further rate hikes from the Fed through 2016 and beyond are also expected to be done through this mechanism. Chart 3: US RRP, IOER and Effective Fed Funds rate The US equity market is heading into the close stronger. The Dow is trading up around 1.0%, with the S&P500 up around 1.1%. The US dollar (USD) is little changed, with the Dollar Index Spot (DXY) at 97.97 from 98.22. The Euro (EUR)/USD is trading around 1.0915 from 1.0930, with USD/Japanese Yen (JPY) at 122.15 from 121.70, while the Australian Dollar (AUD)/USD is around 0.7210 from 0.7190. We continue to expect gains in the USD in the months ahead, especially against both the EUR and the JPY as the European Central Bank and Bank of Japan continue their more aggressive QE programs. A lower AUD could also be expected, as commodity prices continue to adjust lower and the Reserve Bank of Australia s bias remains to the downside. Chart 5: USD Index Source: Bloomberg. Data to 16 December 2015. Note Fixed Reverse Repo operations will be offered at 25 basis points effective 17 December 2015 Financial markets Markets have responded relatively positively to the Fed s decision to begin the monetary policy normalisation process as it was well priced into markets. 10 year government bond yields are up around 2bp at 2.29% from 2.27%, while 2 year yields are up around 4bp to 1.01% from 0.97% - slightly flattening the yield curve. Source: Bloomberg. Data to 16 December 2015 Chart 4: US Fed Funds Rate, 2-year and 10-year bond yields Source: Bloomberg. Data to 16 December 2015 4

For further information please contact: Stephen Halmarick Head of Economic and Market Research +61 2 9303 3030 shalmarick@colonialfirststate.com.au James White Senior Analyst, Economic and Market Research +61 2 9303 2645 jwhite@colonialfirststate.com.au Belinda Allen Senior Analyst, Economic and Market Research +61 2 9303 2495 ballen@colonialfirststate.com.au Disclaimer Product Disclosure Statements (PDS) and Information Memoranda (IM) for the funds issued by Colonial First State Investments Limited ABN 98 002 348 352, and Colonial First State Managed Infrastructure Limited ABN 13 006 464 428 (collectively CFS) are available from Colonial First State Global Asset Management. Investors should consider the relevant PDS or IM before making an investment decision. Past performance should not be taken as an indication of future performance. No part of this material may be reproduced or transmitted in any form or by any means without the prior written consent of CFS. This material contains or is based upon information that we believe to be accurate and reliable. While every effort has been made to ensure its accuracy we cannot offer any warranty that it contains no factual errors. We would like to be told of any such errors in order to correct them. This material has been prepared for the general information of clients and professional associates of CFS. You should not rely on the contents. To the fullest extent allowed by law, CFS excludes all liability (whether arising in contract, from negligence or otherwise) in respect of all and each part of the material, including without limitation, any errors or omissions. This material is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render specific advice. It is not an offer document, and does not constitute a recommendation of any securities offered by CFS. No person should act on the basis of any matter contained in this material without obtaining specific professional advice. Colonial First State Global Asset Management is the consolidated asset management division of Commonwealth Bank of Australia ABN 48 123 123 124. Copyright (2015) Colonial First State Group Limited. All rights reserved. 5