Fed’s Hawkish Hold

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The Federal Reserve is most unlikely to raise interest rates tomorrow, but its statement should leave little doubt of the trajectory of rates over the next six months. The market has fully discounted two more hikes this year and has begun pricing in a third hike too. As of the end of April, the January 2019 Fed funds futures contract has about 20% of a third hike being discounted.

Fed officials have limited their own flexibility by hiking rates only at meetings followed by press conferences. This may have been needed in 2015 and 2016, but surely, the practice has outlived its usefulness. It effectively reduces the number of live meetings to four from eight. And if it is deemed appropriate to hike rates four times in a year, there is not much room for error. Recall that back in 2015, the Fed seemed prepared to hike rates in September, but due to a disruption in the global capital markets, arguably stemming from China, it chose to wait.

The Greenspan Fed has been criticized for raising rates predictably 25 bp at each meeting in an early cycle. Now the Fed’s own dots (forecasts) point to a hike nearly every other meeting. Is that sufficiently different to avoid the Minsky pitfalls?

Strategic ambiguity often works in the Fed’s interest. What does the Fed’s commitment to raising rates gradually mean? It is not precisely clear. However, we suggest that at the very least, it does not mean raising rates at back-to-back meetings. While the Fed could hold an impromptu press conference, the secrecy would be difficult to manage, and we suspect Powell would not want to take such risks without a greater sense of urgency.

Indeed, a hike now would catch the market off-guard and would spur speculation about the kind of information set that Fed officials may be looking at to justify the move. We have encouraged Fed officials to have press conferences after every meeting (as is common practice for other major central banks such as the ECB and BOJ).

We anticipate a hawkish hold in the sense that the Federal Reserve is likely to make minor adjustments in its statement that recognize the increased confidence of achieving its mandate. Economic growth remains above trend, which, among other things, means that slack is still being absorbed. The labor market is robust. Weekly initial jobless claims made new cyclical lows in April and the unemployment rate was ease to 4.0%, with further improvement in the underemployment as well.

The FOMC statement will likely recognize that the inflation goal has been nearly achieved. Earlier this week, the government reported that the PCE deflator, the inflation measure targeted by the Fed, rose 1.9% y/y. The target is 2.0%. We do not expect the Fed to formally endorse ideas that because inflation undershot, it can now exceed the target with impunity.

Although the fiscal stimulus may have stoked official confidence, the statement may not refer much to it or the growing budget deficit. Those issues may find some airing in the minutes and in other speeches that officials give, but there is little place for it in the statement. The same generally applies to trade tensions, we think.

The Fed can be confident because the mandates are at hand and the impact of the fiscal stimulus still lies ahead. Economists of different persuasions generally agree that the effects of the tax on investment and consumption are barely detectable in the early days.

However, we detect a greater belief on Wall Street than in Washington that the economic expansion is mature, and signs of late-cycle characteristics are evident. These include: the 12-month moving average of non-farm payrolls peaked in 2015, the 12-month moving average auto sales in peaked 2016, and credit card delinquencies are rising. In client meetings, the conversation often has moved beyond the terminal rate for Fed funds and toward contemplation of the first cut.

Most immediate though are additional hikes. The FOMC statement should reinforce the already strong expectations for a June and September rate hike, but also encourage the gradual pricing of a December rate hike as well. The US dollar, whose recovery in the foreign exchange market has accelerated, is unlikely to be an issue for the Fed at this juncture. It is still lower on a year-over-year basis (with the Swedish krona -0.1% and the Australian dollar -0.5% the two minor exceptions).

That said the dollar is now turning positive on the year against most of the major currencies. We suspect the weakness in the US dollar in the face of its tightening (and other considerations) was as baffling to policymakers as it was to investors. This suggests that there will be some tolerance for the dollar catching up to where it “ought to have been” before impacting the economy and thus the Fed’s economic assessment.