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Look-ahead to tomorrow’s rate decision from the Fed
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Quote: Spoiler alert! Don’t expect much and you won’t be disappointed

European and US stock indices soared this morning with investors apparently back in full “risk-on” mode. As in previous quarters, traders are using the earnings season as a springboard to drive up equities, pushing the major US indices to fresh records even as there have been a few high profile corporate disappointments, Google being just the latest. The current rally comes despite a steady flow of warnings concerning excessive stock market valuations. We’ve even had a clutch of Federal Reserve members, including Chair Janet Yellen, opine just a month or so ago that equities are expensive by “some measures.” Comments like this led a number of market participants to wonder if the Fed was trying to take some heat out of the market and preparing investors for the time when monetary policy tightened significantly. Certainly, the overall takeaway from the Fed’s last meeting in mid-June was that the US central bank was prepared to disregard a stream of weaker-than-expected US economic data, particularly a downturn in inflation since February, and not only continue to hike rates throughout 2017 but also start the process of balance sheet reduction. According to the FOMC’s quarterly Summary of Economic Projections the Fed anticipates raising rates by 100 basis points between now and the end of 2018. This would be in addition to a gentle (maybe $10 billion per month) balance sheet reduction forecast to begin in the fourth quarter. By contrast, the market expects just 50 basis points of rate hikes between now and the end of next year.

But just a fortnight ago Dr Yellen delivered her prepared testimony to the House Financial Services Committee in Washington. Perhaps the most noteworthy statement came when the Fed Chair addressed the degree of monetary tightening we should now expect: “Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.” This dovish statement took investors by surprise. The fed funds rate currently trades in a band below 1.25%, and the general consensus was that the Federal Reserve would keep tightening until rates got up to 3% or thereabouts. That implied another seven rate hikes of 25 basis points each. Assuming the Fed hiked each and every quarter (which they wouldn’t anyway) they’d achieve 3% in March 2019. And all this is regardless of any balance sheet reduction. So, the question now is what does the Fed consider a neutral rate for fed funds? Some analysts now believe this could be as low as 1.75-2.00%. If so, then the Fed is over half way to its target.

Janet Yellen certainly threw a bucket of water over the hawkish flames which had been fanned by the Fed since June. This could simply be an attempt to reassure investors that the US central bank won’t tighten regardless and will continue to back-stop bonds and equities. This would be a response to concerns in some quarters that the Fed was no longer data-dependent; that it was prepared to blindly raise rates even in the face of falling inflation or other signs that the US economy was faltering. In fact, the Fed has now made it clear that economic data will be an important factor in future rate decisions. This has helped to reassure those investors concerned that the US economic recovery isn’t as robust as the Fed would have us believe.

So we shouldn’t expect any change to rates tomorrow evening. That’s certainly what the market is telling us. The CME’s FedWatch Tool indicates that there is just a token 3% chance of any kind of change taking place. But nevertheless, analysts will be parsing tomorrow’s statement closely just to make sure this new-found dovishness isn’t simply another short-lived Fed-fad.

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Posted by David Morrison

Tagged: Bulletin PM briefing

Category: PM Bulletin


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