Fed's Dec meeting: Market not factoring Fed projections for 3 rate hikes in 2018

United States Federal Reserve Chair Janet Yellen holds a news conference following the two-day Federal Open Market Committee meeting in Washington, U.S., September 21, 2016. REUTERS/Gary Cameron TPX IMAGES OF THE DAY - RTSOU1R

Anubhav SahuMoneycontrol Research

The US Fed’s December meeting decision was on expected lines. The change in dynamics this time around is the improved growth prospects on account of tax changes and market’s expectations for fewer rate hikes next year. Should markets catch up with Fed's expectations as they did in 2017 when owing to higher yields in US, fund flows headed back?

Dot plot: Three rate hikes in 2018 expected

As expected, Federal Reserve has increased the funds rate by 25 bps, thus moving the target range for the federal funds rate to 1.25 to 1.5 percent. This is the fifth such rate hike in this interest rate normalization cycle. As per Federal Reserve dot plot, median expectations remains for about three rate hikes in 2018 and two/three in 2019.

Federal Reserve expects a gradual increase in policy rate to continue till it reaches a neutral rate, which in itself is expected to remain lower than the levels prevailed in previous decades.

Federal Reserve: Dot plot

Growth expectations

The Federal Reserve has changed the growth forecast for the near and medium term. Particularly, for next year, growth projection (real GDP) is 2.5 percent (from 2.1 percent in September 2017). Improved GDP growth outlook is attributed to the expected changes in tax code. Additional improvement is seen for unemployment numbers which is expected to be about 3.9 percent in 2018.

However, inflation numbers are essentially same. Core inflation (excluding food and energy) was 1.4 percent in October.  FOMC continues to believe that current year’s inflation softness reflects transitory developments that are largely unrelated to broader economic conditions; hence, it is expected to reach 2 percent in the medium term (by 2019).

Table: Economic projections of Federal Reserve Board members

Balance sheet normalization

Balance sheet normalization process remains as expected but with a rider that if there is material deterioration in the economic outlook, reinvestment can resume.

Change in language for labour market

The Federal Reserve mentioned that there is a change in the statement’s language for the labor market. While FOMC considers labor as strong, it expects the pace of job gains to moderate over time as it gradually reduces the degree of monetary policy accommodation.

Two dissenting votes

Voting against the action were Charles L Evans and Neel Kashkari, who preferred at this meeting to keep status quo, probably given the subdued inflation numbers.

Market’s implied probability for 2 rate hikes in 2018

While median projections are for 3  rate hikes next year, the market implied probability for fed futures suggests two rate hikes with ~60 percent probability for a rate hike in March. So, clearly, the market remains cautious and keeps a relatively dovish expectation during Jerome Powell’s regime.

However, that said, prospects of huge repatriation of fund flows due to tax code changes and a continued rise in policy rate have kept the other central banks on the edge.

For instance, China’s central bank has modestly increased the borrowing cost (+5 bps) to provide reasonable expectations for interest rates and prevent financial institutions from adding excessive leverage and expanding broad credit supply, as per PBOC.

Real interest rate differential is worth a look

In this context, other central bank meetings become an interesting set of events to look at in this global interest rate normalization period. Another trend to look at is interest rate differentials which has in recent times remained favorable for India but this can change soon. Particularly, when inflation is inching up in India, real interest rate differential may not be favourable in times to come.

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