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FOMC Preview: Rates to rise, but what does ‘gradual’ mean?

11-Dec-2015

The FOMC meets on Tuesday and Wednesday next week, with the release of its decision, the accompanying statement and Projection Materials (including the ‘dot plot’ of member interest rate projections) at 19:00 GMT on Wednesday. Below our Economists preview this historic event.

The press conference will follow at 19:30 GMT, where Chair Janet Yellen will read an elaborated version of the statement, followed by a Q&A session. Our own view corresponds to what is now the overwhelming consensus, which is that the committee will increase the Fed funds target range by 25bps to 0.25%-0.50% this meeting. The main focus will be on the tone of the statement, the committee’s forecasts (including the ‘dots’), the Chair’s press conference comments and any other qualitative information regarding the gradual pace of tightening.

After the decision to leave rates on hold in September due to potential dampening effects from ‘global economic and financial developments’, market expectations of a first hike were moved back to the December meeting, with the October meeting largely ignored. Over the past three months, risks to the outlook have changed, as Chinese led market volatility has ebbed. Indeed, risks were noted by Yellen last week as being “very close to balanced”. Domestically, she presented an “overall picture of above trend growth”, highlighted that data since the October meeting was consistent with improving labour markets and that she was confident that inflation will rise towards the Fed objective. Even dovish Chicago Fed President Charles Evans admits that “the data suggests that the fundamentals are strong”. It would take a very sudden and dramatic turn of events to change the committee’s mind.

At the time of writing the Fed funds future was implying a 78% chance of a 25bp hike at this meeting. Fed members Bullard and Williams have said that they do not expect markets to be surprised by the first hike or for there to be much ‘excitement’ in the days that follow the meeting, suggesting that the markets have pricing about right, and no great fallout from a hike is expected. While we concur, what markets are really looking towards are hints of the pace of tightening through the course of 2016.

October’s statement reminded markets that rates are likely to remain at relatively low levels for some time, and various Fed members have spoken about a gradual pace of tightening. But what pace is ‘gradual’?. In September (when the most recent Fed forecasts were published), the committee’s dot plot suggested a median view for the funds target of 1.25%-1.5% for end-2016 and 2.5%-2.75% for end-2017. This lies above than the path implied by markets, namely 0.75-1.0% and 1.25-1.5%, respectively. Were committee members to stand by this projection and to guide towards a speedier set of rate increases, this divergence between market pricing and Fed thinking would need to be resolved.

But this might not be a feature of next week, especially as the committee is likely to stress that the policy outlook will be highly dependent on the evolution of the economic data. Indeed it may be that closure overrides risk markets’ aversion to tighter policy in the immediate aftermath of next week’s decision.

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