US Federal Reserve back in the limelight

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The whirlwind of Trump policies has taken the spotlight off the Federal Reserve’s path for monetary policy since its 14th December meeting at which it hiked rates 25bp.

Mixed US macro data and acute policy and economic uncertainty have likely cemented a pause at today’s Fed policy meeting, as priced in by the market.

However, today’s Fed meeting is significant as US yields and Dollar have edged lower year-to-date, in line with my expectations that the hawkish pendulum had maybe swung too far.

Moreover, today’s meeting – the first since President Trump was inaugurated – will see four new regional bank Presidents, with an arguably more dovish bias, take over from James Bullard, Esther George, Loretta Mester and Eric Rosengren.

I would expect the Fed’s policy statement to highlight the marginal strengthening in the labour market but also the slowdown in GDP growth in Q4, weak housing data in December and still very modest rise in inflation and inflationary expectations.

The Fed may also chose to emphasise the importance of domestic conditions, indicators and developments when setting interest rate policy, a very subtle nod to the increasingly acute uncertainty which the Fed currently faces.

Finally, the ten voting FOMC members are likely to unanimously vote in favour of rates remaining on hold.

I see no compelling reason why, at this juncture, the Fed would want to guide US yields (or the Dollar) beyond their year-to-date ranges. At the margin, the risk is that the Fed tries to stabilise yields, particularly at the long-end of the curve, with an eye on keeping open the possibility of a March rate hike.

Until the Fed has tangible evidence that macro policy-promises are being enacted and it has conducted an initial evaluation of these policies’ possible impact on the US economy, the Fed may disappoint market participants expecting a marked step-up in the hiking cycle from the one-a-year hikes delivered in 2015 and 2016.

Focus on President Trump’s policies has eclipsed expectations of Fed’s likely no-hike

Only a few months ago, the outlook for US monetary policy vied with the US presidential elections for the market’s attention. But the whirlwind of executive orders signed by President Trump in the first ten days of his presidency – including repealing Obamacare, pulling the US out of the Trans-Pacific Partnership (TPP) and banning immigration from seven countries – has eclipsed the question of when the Fed would next hikes rates. With the media and markets riveted on the ongoing verbal jousting of President Trump’s administration with Mexico, China and Germany, today’s Fed policy meeting has received scant attention.

Moreover, markets will have to wait for the 15th March meeting for Chairperson Yellen’s press conference, updated macro forecasts and revisions to the seventeen Federal Open Market Committee (FOMC) members’ estimate of the appropriate policy rate. Finally, today’s Fed decision should be reasonably straightforward. The Fed is very unlikely to hike its 0.5-0.75% policy rate and the srates market has indeed all but discounted the likelihood of a 25bp hike today. It hiked rates 25bp only six weeks ago and since then US macro data have been mixed while policy and economic uncertainty has become more acute.

Olivier Desbarres Graph 1.1

 

Today’s Fed policy meeting important on a number of levels

However, the content and tone of the accompanying statement to today’s policy decision, which has historically averaged fewer than 600 words, will be important on a number of levels and is likely to temporarily eclipse President Trump’s 140-word tweets:

  • It will be the first meeting since the Federal Reserve hiked its policy rate 25bp on 14th December and FOMC members estimated that three 25bp rate hikes would be appropriate in 2017.
  • It will be the first meeting since Donald Trump was inaugurated President on 20th January and started to enact policies which until then had just been electoral promises.
  • US yields, which climbed vertiginously between the US elections on 8th November and 14th December, have since fallen across the maturity spectrum with US 2-year, 5-year and 10-year yields down about 5bp, 11bp and 9bp respectively (see Figure 1). At the same time the US Dollar Nominal Effective Exchange Rate (NEER), which hit a 14-year high on 3 January according to my estimates, has since weakened about 2.3% (see Figure 2).

This price action is broadly in line with my view, expressed six weeks ago, that analysts and markets may have got ahead of themselves in expecting that reflationary US-centric policies would drive US yields, equities and stronger (see Hawkish pendulum may have swung too far, 21 December 2016). Admittedly the recovery in the EUR/USD cross has come earlier than I had anticipated.

Olivier Desbarres Graph 2

  • It will be the first meeting at which regional bank Presidents Charles Evans (Chicago), Patrick Harker (Philadelphia), Robert Kaplan (Dallas) and Neel Kashkari (Minneapolis) will be voting FOMC members (see Figure 3). As per the convention of rotating regional Bank Presidents every year, they will replace voting members James Bullard (St Louis), Esther George (Kansas City), Loretta Mester (Cleveland) and Eric Rosengren (Boston).

Olivier Desbarres Graph 3.1

This is significant as, historically, regional bank presidents have had more contrasting viewpoints and been more willing to dissent then members of the Board of Governors. While Charles Evans was a voting FOMC member in 2008, 2011 and 2014, it will be first time that Kashkari, Kaplan and Harker are voting FOMC members and they have yet to earn a cast-in-stone hawkish or dovish label. However, in aggregate, the four new voting FOMC members are arguably more dovish than the members they replace (see Figure 4).

 

Policy statement to maintain measured tone with potential nod to uncertainty

Based on precedent, markets will only have a few paragraphs and tweaks of language to assess the Fed’s statement and its stance on monetary policy. I would expect the Fed to:

  • Highlight marginal strengthening in the labour market but also slower GDP growth in Q4, weak housing data in December and still very modest rise in inflation and inflationary expectations.

US GDP growth slowed to 1.9% quarter-on-quarter annualised in Q4 2016 from 3.5% in Q3, according to the “advance” estimate released by the Bureau of Economic Analysis. Soft export data and higher imports subtracted 1.7 percentage points from GDP in Q4.

Employment is at an all-time high and the unemployment rate of 4.72% is near a decade low. The employment growth rate has slowed but that is perhaps to be expected in an economy which has created over 14 million jobs since early 2010, in which the number of unemployed has fallen by 7.5 million and the share of full-time employed has risen from below 80% to 81.7%. However, underlying labour data paint a more mixed picture and there is still slack in the US labour market which may not be immediately apparent in January’s headline data due to be released on Friday, in my view (see Tradespotting: Choose protectionism. Choose higher inflation. Choose weaker trade and growth, 26 January 2017).

Olivier Desbarres Graph 4

For starters, the average number of weekly hours worked has edged lower. Moreover, the potential pool of available workers, which I measure as those unemployed, working part-time and not in the labour force but wanting a job, fell from 49 million at the turn of the decade to 41 million in late-2015 but has since flat-lined. It remains 4.5 million higher than before the great financial crisis, which has likely contributed to the slowdown in nominal wage growth to below 4% yoy (see Figure 5). This has in turn likely held back a more rapid increase in measures of year-on-year core inflation in the past year (see Figure 6).

 

  • Emphasise the importance of domestic conditions, indicators and developments when setting interest rate policy, a very subtle nod to the increasingly acute uncertainty which the Fed currently faces.

Precedent, however, suggests that the Fed statement will not use the word “uncertainty” or pin-point specific areas of domestic policy where the Fed is awaiting confirmation or clarification. The Fed faces at least three levels of acute uncertainty, namely the nature and timing of President Trump’s policies, their impact on the US and global economy in the near and medium-term and their impact on US and global financial markets. The policies which President Trump has so far enacted via executive order have required no spending subject to congressional approval and, with the exception of the United States’ withdrawal from the TPP, are likely to have only a limited direct impact on the US economy.

 

  • Unanimously vote in favour of rates remaining on hold (i.e. no dissentions amongst the ten voting FOMC members). Note that Esther George and Loretta Mester, which both dissented in favour of a 25bp hike at the November 2016 policy meeting, are not voting FOMC members this year.

From a market perspective, I see no compelling reason at this juncture why the Fed would want to guide US government yields beyond their year-to-date ranges or would be particularly worried about the Dollar’s recent and in the greater scheme still modest depreciation. At the margin, the risk is that the Fed tries to stabilise yields, particularly at the long-end of the curve, with an eye on keeping open the possibility of a March rate hike.

 

Fed can do without certainty but needs economic policy to come into clearer focus

Until the Fed has tangible evidence that macro policy-promises are being enacted and it has conducted an initial evaluation of these policies’ possible impact on the US economy, the Fed may disappoint market participants expecting a marked step-up in the hiking cycle from the one-a-year hikes delivered in 2015 and 2016.  The nature and timing of the trade and fiscal policies which President Trump pushes through are in any case likely to have a bearing on the timing of future Fed hikes.

If President Trump proceeds with a set of protectionist policies, including a renegotiation of or withdrawal from NAFTA and the imposition of tariffs on US imports, this could have materially larger ramifications with the risk near-term of higher US inflation, weaker US trade and growth as I argued in Tradespotting: Choose protectionism. Choose higher inflation. Choose weaker trade and growth (26 January 2017). This scenario would arguably pose a dilemma for the Fed.

If and when Congress enacts President’s Trump much-promised tax cuts, which President Trump has pencilled in for the first 100 days of his presidency, the Fed could conceivably start to hike rates at a slightly faster clip, all other things being equal, in order to counter looser fiscal policy. Tax cuts can quickly translate into consumption and investment and feed through to the broader economy in the form of faster growth and inflation.

If and when Congress enacts President’s Trump much-promised infrastructural spending plans, which again President Trump has pencilled in for the first 100 days of his presidency, I would expect the Fed’s reaction function to be somewhat more muted. Costly and complex infrastructural projects are usually prey to significant leads and lags. Various levels of government often need to green-light these projects, funding earmarked and contracts put to tender. Assuming these projects get off the ground, it can be months or years before the economic benefits are felt at a local, state let alone national level.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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