What the FOMC Says may be More Important than What it Does

What, FOMC, Says, More Important,What it Does, Fundamental Analysis, fx trader, forex

Provided that the Federal Reserve delivers the widely tipped and expected 25 bp hike in the Fed funds target range, the key to investors' reaction will be a function of the FOMC statement and forecasts. The FOMC meeting is the last big event of the year for investors. The Bank of England, the Swiss National Bank, and Norway's Norges Bank hold policy meetings, none are likely to alter policy. Several emerging market central banks meet this week, and Mexico is the only one that will likely move. Many expect a 25 bp hike, but there is some risk of a 50 bp move. The Bank of Japan meets the following week, and it too is unlikely to take fresh measures.  

A failure of the Federal Reserve to raise interest rates would be a significant shock and spur a dollar sell-off, a Treasury rally, and probably an equity market sell-off. The likelihood of this scenario is so low that it is not worth much time discussing. Similarly, 50 bp move also is highly unlikely. It would go against everything the Fed has been saying about gradual moves. It would be an admission of getting behind the curve, and there is no evidence that this is their assessment.

Since the FOMC last met, the US dollar has strengthened, interest rates have risen sharply, and the unemployment rate has fallen further. Investors will learn what the central bank makes of these developments. Officials that have spoken since the election have generally agreed that it is premature to make any judgments of changes in fiscal policy or economic policy more broadly.  And for good reasons. It is far from clear the policies of the new Administration.  

There seems to be a broad sense that probably near midyear there will some tax cuts and spending increases, alongside a tougher, perhaps more mercantilist trade policy. The details are vague, and how this sits with fiscal conservative wing of the Republican Party is not clear.  While the intentions and signals of the President-elect have spurred a sizable reaction in the capital markets, more concrete details are needed to begin contemplating the impact on monetary policy.

Therefore, and this is where some investors may be disappointed, the FOMC's economic assessment, and most importantly, their forecasts are unlikely to change very much. Of course, the part of the statement that updates the economic assessment may be upgraded a notch. The headwinds that held the economy below trend appear to be transitory as the Fed had anticipated. The fourth quarter growth looks to be around 2.5%. Consumption may be a little less robust and trade is looking like a drag.

The Fed will have to recognize the rise in market-based measures of inflation expectations. Both the 5-year forward forward and the 10-year break-even rates are up around 30 bp since the end of October to be around 2.0%. There are two mitigating factors. First, the survey-based measures of inflation expectations if anything have softened. The University of Michigan survey found expectations for the next 5-10 years slipped to 2.5% this month from 2.6%. Second, due to technical factors such as liquidity differences, in a rising interest environment, TIPS tend to sell off more than conventional bonds.

All else being equal the appreciation of the dollar and rise in yields would likely have a dampening impact on growth and inflation forecasts. This may be blunted by the further decline in the unemployment and underemployment rates and the wealth effect. And given the uncertainties over the new Administration, most Fed officials are likely to be reluctant to change their forecasts much now, when in three months, visibility will be better.

Specifically, we expect the median dot show expectations for two hikes next year. While this is twice as fast as the pace in 2015 and 2016, it fits any definition of prudent and cautious. A recent Wall Street Journal survey found that among economists three rate hikes are thought likely.

Interpolating from the December 2017 Fed funds futures contract is a trickier. Various possible scenarios calculations and assumptions are needed. Here is a simple one. Assume that the Fed hikes rates in the first half (Q2?), and the Fed funds target range coming into the 13 December 2017 FOMC meeting is 0.75%-1.00%. In the first 13 days December 2017, the Fed funds effective average is 87.5 bp, the midpoint. If the Fed were to raise the target range to 1.00%-1.25%, then the midpoint of the new range is 1.125%.