The FOMC meeting next week will be of even more interest than usual. Commentary from Fed officials in the run up to the meeting has turned more hawkish suggesting that the central bank is edging closer to a rate hike. However, we think a rate hike next week is unlikely. Our base scenario is for a December move, but even then, the case does not seem overly convincing.
Many Fed officials have suggested that the time for higher interest rates is approaching.
Nick Kounis Head of Macro Research
- A Fed interest rate hike does not look likely next week
- We expect a hike in December, though the case for higher interest rates in general is far from convincing
- Meanwhile, the BoJ is likely to announce a monetary easing package
- The combination of a Fed on hold and BoJ stimulus could start to reverse bond market worries of an exit from easy monetary policy
More hawkish Fed commentary
Many Fed officials have suggested that the time for higher interest rates is approaching. Fed Chair Yellen remarked at Jackson Hole that ‘the case for an increase in the federal funds rate has strengthened in recent months’. This seems to be where many Committee members are. They judge a rate hike is getting closer, but have been non-committal on the timing. Indeed, it could be argued that if they were really convinced of a September rate hike, they would have tried to prepare markets more than they have done. At time of writing, markets assign less than a 20% chance to a September rate increase, and that probability has always been comfortably below 50% in recent weeks.
Meanwhile, recent data may have created some doubts about the direction of the US economy, strengthening the case for the FOMC to wait. For instance, retail sales have been soft suggesting that consumer spending is slowing in Q3. The ISM reports deteriorated sharply in August, and are now at levels historically consistent with just 1% GDP growth. We do not think the US economy is set for a slowdown, a moderate growth trend looks likely. However, recent numbers do raise questions.
The exception to this narrative is the labour market. Although nonfarm payrolls slowed in August, the underlying trend remains solid. On the other hand, there is not much sign of inflationary pressure coming from the labour market, and Fed’s preferred measure of inflation remains below target.
A signal for December?
Perhaps an even bigger question than whether the Fed will hike or not, is what its guidance will be about future monetary policy. The new projections will tell us where FOMC members expect interest rates to be in the coming months, as well as where they expect them to settle in the long term. In June, FOMC members saw roughly two rate hikes this year and another 3 hikes next year, so 5 in all to the end of 2017. We think that the FOMC will move closer to our own baseline of one hike this year and two next. The FOMC may also stop short of explicitly signalling a December hike in the FOMC statement. Overall, that would make for a relatively dovish Fed communication even though we are moving closer to another hike.
The new normal
Although we expect a December hike, the case is far from convincing given the economic outlook. One of the key arguments put forward for higher rates is that policy rates are abnormally low and need to normalise. However, it is difficult to know what exactly normal is for interest rates in the current environment. For instance, if interest rates are so abnormally low, why is the economy not booming? One thing that is clear is that the normal or long-run interest rate has come down over the last few year. Indeed, FOMC members have been lowering their estimates of the longer run rate. Indeed, there might be some further decline in the FOMC’s view of where interest rates will settle in the longer term from the 3% they estimated in June (which still seems rather high to us).
BoJ set to expand stimulus
The BoJ meets on the same day as the Fed. Given that underlying inflation (ex food and energy) has fallen back and may even be on the cusp of going negative again, we think it is likely that the BoJ will step up its monetary stimulus. We expect the central bank to cut rates further into negative territory and increase its asset purchase target.
Fed and BoJ could ease bond market worries
Over the last few days, government bond yields have been on the up globally. There have been concerns that central banks are reaching the limits of their unconventional policies, given practical difficulties of adding more stimulus, and perhaps less commitment from policymakers. The possible resumption of the Fed’s rate hike cycle has added fuel to the fire. Of course, it is fair to say that QE programmes are having diminishing returns and central banks have become more cautious in stepping up stimulus over recent months. However, our sense is that global monetary policy will remain relatively accommodative. The combination of a Fed on hold and BoJ stimulus next week could start to reverse bond market worries of early an exit from easy monetary policy.