After the Fed raised interest rates in December through to the beginning of 2016, it was widely expected that the Fed would next raise interest rates at its March meeting on its way toward 4 quarterly rate hikes this year.
The plunge in crude oil and world stock markets over the first six weeks of 2016 upset that apple cart and sparked speculation that the Fed could slow its rate normalization program and perhaps even go the other way.
In the six weeks since the last Fed meeting, oil and stocks have bounced back, the US economy has been a lot more resilient than traders were willing to give it credit for and inflation has started to increase.
Through the market selloff, FOMC members split into three factions.
The dovish group suggested the sky was falling and the central bank should slow or stop the pace of rate hikes. This included NY Fed President Dudley, Governor Brainard and surprisingly was joined by St. Louis Fed President Bullard who had previously been hawkish.
The hawkish group led by Cleveland Fed President Mester and KC Fed President George believe that volatility is common when the Fed shifts direction on monetary policy and that it would all blow over just as it has before, so there’s no reason to change course.
The middle group which includes Fed Chair Yellen and Vice-Chair Fischer stressed the need to keep the Fed’s options open and see what happens before deciding.
So the big question now is which group will win out at this week’s meeting and what signals will the central bank send about future direction? In addition to the statement, the Fed can also use member projections and the press conference to send a signal about its future plans for interest rates.
The recovery in stock markets and crude oil, plus stronger than expected economic reports including nonfarm payrolls, GDP, construction spending, personal spending and durable goods orders have all come in well above expectations. Although this positive trend was offset slightly by this week’s miss and downward revision on retail sales, overall, US economic conditions support ongoing interest rate hikes.
More importantly, however, is signs of rising not falling inflation. The oil price appears to have bottomed out as indicated by the International Energy Agency last week. With this turnaround not only are deflation pressures subsiding but the PCE core inflation rate (the measure the Fed uses) has been climbing above expectations with previous reports getting revised upward. Even wage growth, which slowed recently, continues to run well above 2% the Fed’s long term inflation goal. The pressure from inflation on the Fed to raise rates is increasing and the longer the Fed waits, the higher the risk it may fall behind on the curve and be forced to slam on the brakes at some point.
There’s been some question over whether the market is ready for a rate hike or not. Although bonds are pricing in only a 4% chance of a rate increase in March, expectations for the next rate hike coming in April (24%) or June (43%) have gone up dramatically in recent weeks. It wouldn’t take much from the Fed to prepare traders for a spring rate increase that could keep it on track for 2-3 hikes this year rather than 4.
Currency markets, meanwhile, already appear to be ready for the Fed to keep raising rates. Between the fall of 2014 and the fall of 2015, the US dollar Index rose from near 80 to near 100 pricing in an aggressive rate hike program. Since the first rate increase in December, the US Dollar Index has actually gone down. Recently trading above 95 in the top quarter of the range, currency traders are still pricing in several rate increases this year, so a hike may not push USD much higher.
In fact, the way markets have been reacting to dovish moves and talk from other central banks suggests that traders are increasingly thinking the recent stimulus cycle is ending and the Fed is leading a more hawkish trend. Instead of sending their currencies lower as one would have thought, recent stimulus moves by the Bank of Japan and the ECB sent JPY and EUR sharply higher with traders thinking they are likely now done. SEK, another negative rate currency has been bouncing back with further cuts looking less likely as Sweden’s economy improves. Even GBP has started to bounce back with trading having priced in the Bank of England shifting from hawkish to neutral and Brexit vote uncertainly.
Overall, it looks like the runway is clear for another US rate increase the question is whether the Fed will pull the trigger now, or send a signal that it’s ready to move in the spring. Following the last round of volatility in August the Fed tried to signal a hike in September which got scuppered, signalled again in October and then acted in December.
This time around, the odds look like this:
Rate increase in March 20%
There isn’t really any economic reason to wait and an early increase would signal confidence in the US economy, but the Fed may decide to give a bit more time for data and markets to confirm things are back on track.
Hold interest rates and signal toward an April or June hike 70%
This appears most likely. The Fed can signal hawkish intentions by raising its GDP, inflation (most likely) or Fed funds projections, or lower its unemployment rate projection (less likely as US nears full employment). Comments on inflation may be most significant as it was deflation fears from falling oil that spooked the doves the most.
A pause and hawkish signal could placate the doves and buy time for the neutral group.
A signal toward an April hike could also help the Fed take back control of the agenda from traders. Over the last year, Fed members have been trying to squash a notion in the market that it would only act at meetings where a press conference is scheduled and remind people that all meetings are live. For many decades the Fed changed rates and policies with no press conference and an April hike would remind everyone of that and bring back the fear of the Fed that has been lost in the era of transparency and complacency.
Hold interest rates and be vague on future direction 5%
This could keep the doves and neutral group happy but runs the risk of sending a negative signal about the economy to the markets.
Narrow the target band to a point by raising the lower bound to 0.50% 5%
At some point the Fed will probably go back to a target point from a target band. This kind of move could make everyone happy (or everyone unhappy) by doing something and sending a signal without doing something. Since this can really only be used once though, the Fed may hold off because doing it too soon could suggest indecision and impact the Fed’s credibility.
Cut interest rates back to the 0.00% to 0.25% range 0%
This looks less likely by the day with the economy growing, inflation and oil rising and markets on the rebound. Such a move would do a ton of damage to the Fed’s credibility and could spark a panic about the state of the US economy.
Cut US interest rates into negative territory 0%
The Fed put out a trial balloon last month that it was looking into negative interest rates but has been quiet on this topic since. It looks to me like the Fed was sending a message to the other central banks not to use negative rates as a tool to devalue their currencies and boost their economies at the Americans’ expense.
In terms of the vote, any decision not to raise rates is likely to be met with at least two hawkish dissenters (Mester and George). A hike decision or signal may bring out 1-2 dovish dissenters among the regional Fed presidents but this is less likely. Remember permanent voters go with the party line and rarely dissent.
One other question about this Fed meeting is what members may say about how many rate hikes this year they expect through the famous (or infamous) dot plot. Recall the party line at the start of the year was 4 hikes, by mid-February the street had gone to zero hikes at the peak of the panic and the truth, as always, is likely somewhere in between. Currently bond trading in Fed Funds is pricing in a 20% chance of no hikes by December, a 38% chance of one hike, a 28% chance of 2 hikes, a 105 chance of 3 hikes and a 2% chance of 4 hikes.
There are 6 Fed meetings remaining in 2016 after this week, so 2-3 hikes are definitely possible, particularly if the April and July meetings become open. September and October still look less likely for a move due to the election campaign and December is a coin toss depending on the result.
Hawkish news or signals would likely spark a rally in USD toward but not through 100.00 for the US Dollar Index. Stocks could fall initially on a hawkish Fed but then rally as traders take hawkishness as a signal of a positive environment for corporate.
A surprisingly dovish move or signal could send stocks up briefly and then sharply lower as it would undermine confidence in the US economy and rekindle recession talk. USD would likely plunge in this case as well.
A wishy washy or neutral Fed could spark confusion and send markets swinging in both directions as traders try to figure out whether liquidity or the economy are more important.
So it looks like this time around, the Fed is likely to remain on hold, but the signals it sends about the outlook for the US economy and interest rates could have a big impact on trading in USD pairs and US stocks.