The Federal Open Markets Committee (FOMC) meet today ahead of the final announcement of the year tomorrow at 2pm EST/7pm GMT. We have forecast a 0.25% increase in the Fed Funds Rate (FFR) in December since June. Markets are now fully aligned with this view, with implied probabilities from interest rate markets assigning a 100% probability of a hike tomorrow and 66 of 67 analysts surveyed by Bloomberg also looking for a hike.
A decision not to increase rates tomorrow would be a major surprise. This has not been Fed policy in recent years: if the FOMC had any doubts about the prospect of tightening policy “relatively soon” as indicated in November, commentary would likely have been more cautious. It has not been.
Given this near certainty for a FFR hike tomorrow, markets will focus on the outlook for 2017 and beyond. An update to the Summary Economic Projections (SEP) and Fed Chair Yellen holding a press conference from 2.30pm EST/7.30pm GMT provides such an opportunity. However, we think the Fed will disappoint markets. To our minds, the key developments next year will be the policies of the incoming administration. We and markets tentatively draw to conclusions that the President-elect will follow a pre-growth, tax reform fiscal stimulus (to varying degrees), while implementing less protectionism than characterised on the campaign trail. We accept there are risks around this policy pre-emption. However, the Fed is not in the business of anticipating changes in government policy and the outlook for 2017 that it will present tomorrow will not be based on any possible fiscal lift.
As such, we expect only modesty changes to the Fed’s SEPs. Growth could edge higher from the estimated 1.8% (Q4/Q4) for end 2016 – our own forecast is for a firmer 2.0% – and the economy’s solid close to 2016 may see some upward adjustment to the 2017 outlook. Moreover, November saw unemployment drop to 4.6% and the Fed may lower its estimate for 2017 unemployment in the light of this (our forecast remains at 4.6% for 2017 as a whole).
However, at the same time, since last month’s elections we have seen a marked rise in both the trade-weighted dollar (3.25%) and in US Treasury yields (63bps). This tightening in financial conditions is likely to leave FOMC participants wary of material adjustment to their rate projections over the coming years (the ‘dot plot’). As such, markets may receive Fed Chair Yellen’s press conference as relatively dovish tomorrow.
Our own view is consistent with the Fed’s rates projections in September. We expect to see a cautious Fed (in the light of tightening financial conditions and little initial lift to economic activity) raising rates twice in 2017 and three times in 2018, leaving the FFR at 1.75-2.00% by end-2018. Our view is predicated on a fiscal lift to US activity that we expect to prolong the economic cycle. Without this lift, we are wary of the headwind to activity that rising inflation would create for consumer spending. Our assessment, therefore, is subject to risks surrounding the political uncertainty over the new administration’s policy goals, which we only see clarifying in the run up to Inauguration on 20 January.
David Page, senior economist at AXA IM