AXA: Ein Tag, der in Erinnerung bleiben wird, aber was kommt morgen?

The Fed fulfilled its promise this month and hiked the Fed funds range by 0.25% for the first time in nine years. It also stated it would not shrink its balance sheet until rate normalisation was ‘well under way’. The Fed acknowledged that inflation remained below mandate level and that survey evidence of inflation expectations had edged lower. It repeated that it would assess expected and actual evidence of inflation rising ahead of future policy moves. However, the Fed continues to project an expectation of four rate hikes next year, describing these as gradual, with no fundamental shift in its other economic projections to signify a more dovish outlook than in September. In this sense, the Fed failed to deliver a ‘dovish hike’. We continue to expect a tightening in financial conditions to lead the Fed to deliver just three hikes next year. Yet financial markets took today’s move in its stride, with little today deviating from broad expectations.

The Fed tightened monetary policy today raising the FFR range by 0.25% to 0.25-0.50%. This was in line with wide-spread expectations following clear Fed communication. With conditions greatly changed in the US money market since 2006, the Federal Open Market Committee (FOMC) issued a note on monetary policy implementation. The top of the FFR range will be governed by interest paid on reserves (IOER). The bottom of this range will be supported by overnight reverse repo operations (ON RRP) and term operations, which will be conducted at 0.25%. While these facilities have been tested by the New York Fed in recent years, there is some uncertainty as to the scale of operations needed to insure overnight rates do not drift below the lower bound. Hence the FOMC temporarily removed the ‘cap’ on the size of ON RRP. There was no dissent on the FOMC. 

The Fed also announced a modification of its balance sheet policy suggesting that it would not stop or taper reinvestment of maturing Quantitative Easing (QE) assets until normalisation was ‘well under way’ (previously it had simply said this would start after lift-off). This was a clarification that we had long anticipated and echoed a similar recent statement by the Bank of England. Other market commentators had expected some cessation of reinvestment from mid-2016. Fed Chair Yellen further explained that this was not something she expected to happen ‘very quickly’ and that the purpose was to have some scope to use the FFR as a future tool of stimulus and minimise the risk of approaching the zero lower bound again.   

The FOMC had been expected to deliver a ‘dovish’ hike – yet in the event the FOMC did little to sweeten the pill of tighter policy.

Economic forecasts saw little change: 

• the median estimate of Q4 year on year GDP was nudged higher to 2.4% from 2.3% in 2016, but were otherwise unchanged; 

• unemployment was forecast marginally lower at 4.7% from 2016 onwards (from 4.8%); 

• and headline and ‘core’ personal consumption expenditure (PCE) inflation was forecast marginally lower to 1.6% (from 1.7%) in 2016, but was otherwise unchanged. 

• Longer run estimates of the these factors were unchanged. 

• Moreover, the Fed saw little adjustment in the median estimate of future rates, although some of the higher forecasts were lowered. 

At the same the FOMC’s statement included a number of modest changes. The statement highlighted that the Fed’s conditions for a rate hike – further improvement of the labour market and reasonable confidence that inflation would return to target in the medium –term – had been fulfilled. The labour market was described as having improved ‘appreciably’. The assessment on inflation was unchanged. However, it was noted that survey-based measures of expectations, that had long been noted for their stability, had ‘edged down’. More pertinently the Fed added ‘the Committee will carefully monitor actual and expected progress toward its inflation goal’.    

Most importantly, Fed Chair Yellen’s press conference did little to overtly suggest a more dovish assessment. She was questioned on the inflation outlook and repeated that actual progress was required, but refused to be pinned down on any metric or timeframe of such an assessment. She highlighted the FOMC’s assessment that risks were balanced. The Fed Chair provided the Fed’s justification for a hike, which having fulfilled the conditions posed by the Fed was broadly to avoid the risk of the need for a future abrupt tightening, which she said might increase the chances of prompting recession. She also emphasised that the Fed’s policy outlook was for an expectation of gradual tightening and one that would likely not be even-paced. 

Markets took the Fed’s hike very much in their stride. 2-year yields rose by 2 basis points to 1.00%, but 10-year yields were a touch softer at 2.29% at the time of writing. The dollar inched higher against the euro, yen and on the Bloomberg DXY basket. While stocks reacted to the message of the Fed’s confidence in the economy the S&P 500 index rose 1% to 2074. 

What does the Fed do next? Its own members median view suggests four hikes next year, something that a modestly more hawkish constituent of voting members may facilitate. Markets still price an end-2016 Fed funds range of 0.75-1.00%, just two hikes. Our own view is for three rate hikes. We suspect that a tightening in financial conditions will at some point next year see the FOMC eschew an even quarter-per-quarter pace of tightening, something Chair Yellen herself suggested. With further disinflationary pressure rising at present, we consider the likelihood that the Fed has seen insufficient evidence of inflation pressures to justify a move in March and we forecast the next move in June. However, until such a tightening in conditions emerges, the Fed looks set to proceed on the basis that it requires further tightening over the coming quarters to make sure inflation only rises back to target. 

Author: David Page, Senior Economist at AXA Investment Managers (AXA IM)