After one year, the Federal Reserve has hiked rates again, signalling that next year it may do so again three on three occasions instead of two. This time, the markets seem to believe the Fed, helped by expectations for aggressive federal tax cuts next year….
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The FOMC meeting came to an end with the expected 25bp rate hike, voted unanimously. The statement and macroeconomic projections signal improved confidence in the strength of the recovery and in the achievement of the full-employment and 2% inflation goals. Although Yellen maintained a cautious stance, the overall message was more hawkish than expected.
The main change introduced by the meeting is the upward shift of the estimated median in 2017 (implying that the median forecast is now for three rate hikes in the year) and, marginally, of the long-term interest rate as well (from 2.9% to 3%). During her press conference, Yellen stressed that such marginal movements in terms of size and scope should not be given too much weight. In both the statement and the press conference the Fed reasserted that the hikes will be gradual and dependent on the evolution of the scenario.
However, the sign of the derivative is an important indicator of the change in regime, after years in which the point of arrival of interest rates pushed down.
This reflects a much brighter assessment of the labour market, which emerges from both the statement and the macroeconomic projections. Risks are still considered as being “broadly balanced”, but downside risk factors of international origin are no longer singled out. Monthly data have resulted in an upward revision of forecast growth in 2016 (to 1.9% from 1.8%) and in 2017 (to 2.1% from 2%). According to the FOMC, GDP growth should stay at levels above potential (1.8%) throughout the forecasting horizon. For the unemployment rate the projection is 4.7% in 4Q 2016 (from 4.8%), and most importantly, a stabilisation at 4.5% is expected in the next three years, three tenths below the equilibrium rate, still estimated at 4.8%. As regards the deflator, the only change concerns 2016 (1.5% from 1.3% y/y in 4Q), whereas the 2% goal is still forecast to be achieved starting in 2018, for both the overall index and the underlying index.
These changes compared to the September picture were made even without openly taking into account potential fiscal stimulus, still too uncertain at present in terms of timing, modalities and size to be incorporated into the scenario. According to Yellen, some FOMC participants, but not all of them, have already incorporated “some assumption of a change in fiscal policy into their projections”. Plans to cut taxes and step up federal spending may have effects on growth and inflation, although there is “time to wait to see what changes occur”.
However, the Fed Chair said that fiscal stimulus “is not obviously needed” to achieve full employment, which has already been reached thanks to monetary policy.
In conclusion, the December meeting certifies the change in regime under way in the US economy: growth is more solid and risks could be skewed to the upside in 2017, once the new administration’s fiscal policy guidelines will have been disclosed.
The Fed will remain cautious in hiking rates for two reasons:
1) the strengthening of the dollar and the rise in long-term yields will already make financial conditions tighter;
2) fiscal stimulus is still uncertain and should start to have significant effects mostly starting in 2018. If, as is likely to be the case, a well-defined fiscal policy plan will not be announced before 2Q, for the time being we may assume that rates will be left unchanged in 1Q, and that the next hike will come in the spring. However, the markets have now resumed heeding the central bank’s guidance: two hikes are fully priced in, a third at least in part.
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