Chart of the month - December
The FOMC’s Federal Funds Rate can be used as an indicator of how expensive it is for institutions to borrow, and therefore the level of all other interest rates in the US economy. In this chart, Janet Mui, reviews the recent rate change and considers the expectation of three more rate changes this year.
As expected, in December the US Fed increased its Fed funds rate (FFR) by 0.25% to between 0.5% and 0.75%. This was the first and only increase in 2016 and just the second in 10 years. The surprise was in the so-called “dot plot”, which shows the Federal Open Market Committee’s (FOMC) median FFR expectations. The upward shift in the “dots” shows the FOMC now sees three rate increases in 2017, up from two previously. It continues to expect three hikes per year in 2018 and 2019, with the median rate projections for the end of 2017, 2018 and 2019 of 1.4%, 2.1% and 2.9%, respectively. The longer-run rate projection was raised from 2.9% to 3.0%.
In both the statement and press conference that accompanied the rate change the FOMC projected a more hawkish tone, a consequence of the continuing tightening in the labour market and the rising trend in inflation. It might be remembered that in December 2015, the FOMC suggested there would be four rate increases in 2016. Eventually it only pulled the trigger just once, largely as a result of adverse external factors and a strong US dollar that negatively impacted corporate earnings. So, the obvious question for 2017 is whether this time the Fed will do what it says.
Potentially, external events and renewed strength in the dollar could again derail the Fed’s plan, but the requirement to move towards policy normalisation, albeit at a very slow pace, looks greater in 2017 than in 2016. Removing one possible impediment to policy tightening, analysts are factoring in better corporate earnings growth in 2017 and 2018, helped by President Trump’s proposed tax reductions and wider fiscal stimulus, which together should more than offset the negative impact of a strong US dollar. This is in stark contrast to the situation in 2016 when earnings expectations were revised down sharply due to the “double whammy” of a stronger US dollar and weaker oil prices. More generally, sentiment in the corporate, consumer and homebuilding sectors has surged to multi-year highs since the election, suggesting that the economy is now on a much stronger footing than a year ago.
Alongside faster growth, headline inflation will likely rise above 2% thanks to the recovery in energy prices and a pickup in wage growth (the latter reflecting an increasingly tight labour market). Again, this will contrast with the situation in 2016 when, for much of the year, Consumer Price Index inflation hovered around the 1% mark.
Markets are now pricing in the next US interest rate hike for June 2017. If the current economic momentum is sustained and wage growth accelerates, the Fed could well tighten again earlier than markets are currently expecting. Nonetheless, the pace and extent of Fed action will remain heavily influenced by both the trend in the dollar and the incoming administration’s fiscal actions.
It will be important to gauge how monetary tightening by the Fed influences the mood in other central banks. The UK’s growth and inflation profile is similar to that of the US. While this may put pressure on the Bank of England to raise rates, it is likely to use Brexit uncertainty as the excuse to keep policy on hold, unless inflation overshoots significantly. Meanwhile, Mr Draghi’s recent rhetoric suggests that the European Central Bank will remain accommodative, although pressure for a change of course may emerge from Germany later in the year. The Bank of Japan is also likely to maintain its distance from the Fed’s tougher stance, given continuing dull growth. Moreover, with 10-year government bond yields already above 0%, there are likely to be more questions with regard to the efficacy of its policy of “yield-curve control”.
Janet Mui, CFA is the global economist at Cazenove Capital, the wealth management division of Schroders. Janet is responsible for the formulation and communication of Cazenove’s top-down views. She is a member of the investment committee that oversees strategic and tactical asset allocation at Cazenove. Janet is also the macro spokesperson and a regular commentator at major media outlets including the BBC, Bloomberg and CNBC.
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