Federal Reserve set to raise rates

By David Morrison  |  12/06/2018 14:55

Markets expect another rate hike from the Fed. But the US central bank could surprise in other ways
 
The Fed concludes its two-day FOMC meeting on Wednesday. The US central bank is expected to raise rates by 25 basis points, pushing fed funds into a target range of 1.75-2.00%. This would take the headline US interest rate to its highest level since September 2008, at the height of the Great Financial Crisis.

Full employment

But the rate hike aspect of this meeting is of secondary importance to what the Fed communicates to the markets. First off, there’s the accompanying FOMC statement. Committee members are expected to express the ‘full employment’ part of the Fed’s dual mandate has been met. It’s difficult to argue otherwise with the Unemployment Rate at an 18-year low of 3.8%. However, this brings its own problems as wage growth has failed to pick up despite a tight labour market. It’s likely that the Fed will have some comments to make on this issue.

Inflation ticking higher

When it comes to the ‘price stability’ part of the mandate, it depends which number you choose to look at. Core PCE (the Fed’s preferred inflation measure) stands at +1.8% annualised, just below the FOMC’s 2% target. Meanwhile, on Tuesday CPI for May came in at 2.8% annualised, its highest level in over six years while the ‘Core’ reading (which excludes volatile items such as food and energy) rose to 2.2%. Now the Fed has made it abundantly clear that it is prepared to see core inflation overshoot its 2% target – perhaps for some time. But what matters is the FOMC’s forecasts for the rest of this year and beyond.

FOMC forecasts

As this is a quarterly meeting there’s also an update to the FOMC’s Summary of Economic Conditions. This is where the Committee presents its forecasts for GDP growth, unemployment, inflation and the fed funds rate for the next two years and beyond. If the FOMC upgrades its outlook for economic growth then we should also expect another upward shift in the ‘dot plot’ of individual members’ expectations for future rate hikes. Back in March the ‘dot plot’ forecast a total of three 25 basis point rate hikes in 2018. If this remains unchanged then that would mean just one more increase is predicted (after a June hike) for the rest of this year. But if the Committee indicates an improved outlook for growth, a rise in inflation and further falls in unemployment then this increases the probability of an additional 50 basis points increase before the year-end. Bear in mind that back in March the FOMC’s ‘dot plot’ showed an upward shift in rate hike projections for 2019 and 2020 when compared to December’s Summary. This saw the forecast median fed funds rate rise to 3.4% in 2020 from the 3.1% forecast in December.

Increased hawkishness?

On the one hand any increased hawkishness could prove bullish for equities as companies should profit from economic strength. But the flipside is that tighter monetary conditions will make it much harder for corporates to improve on their current performance. In addition, we’ve just had an exceptionally strong set of first quarter earnings which means that it’s going to get harder for companies to outperform going forward. This fact won’t be lost on investors in equities.

Watch the dollar and yields

Nor will it be lost on the bond market. Any upward shift in interest rate expectations should lift the dollar and put upside pressure on US Treasury yields as bond prices sell off. This could be a concern if it leads to a further flattening of the yield curve, particularly if the Fed emphasises that it expects inflation to continue to rise.

Caution required

Given the strength of recent US data releases, particularly the latest Manufacturing and Non-Manufacturing PMIs, it seems most unlikely that the Fed will present a downbeat view of the US economy. But it will have to be very careful not to appear too upbeat or investors will start to worry about the central bank becoming too restrictive. Some analysts are speculating that the Fed may calm fears about tighter monetary policy by indicating that it is prepared to reduce its balance sheet from $4.5 trillion to $3.5 trillion, rather than to $2.5 trillion generally expected. Since October last year the Fed has reduced its holdings of Treasury debt and mortgage-backed securities by $102 billion – barely a dent in its holdings. But this has been enough to raise concerns of a global shortage of dollars down the line which is one of the reasons for the recent plunge in emerging market debt.
There are plenty of moving parts to consider, and that’s before we get to Fed Chairman Jerome Powell’s press conference. Traders should prepare themselves for a sharp spike in market volatility.
 
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