Regarding our own Fed outlook, we now look for a first hike at the June meeting next year, which is both earlier, and more precise, than our prior call of Q3. As the timing of the first hike draws closer, it becomes appropriate to convey our outlook by meeting, rather than by quarter. The Fed has shown a propensity to make important decisions at meetings that are followed by press conferences. In next year’s calendar such a meeting in Q3 does not occur until late September, which could be too late given the ongoing improvement in the labor market. (Of course, they could, and maybe should, switch to having press conferences at every meeting). Another factor motivating an earlier first move is the apparent revision to the exit principles. The old principles had halting reinvestments and large-scale reserve draining occurring prior to the first rate hike, both of which would have been “baby tightening steps.” With those steps no longer likely to occur before the first rate hike, the timing of that hike should be pulled forward. Finally, Fed rhetoric has turned marginally more hawkish in recent months.
We see the first hike in June as a 25 basis point increase in the target funds rate corridor, to 25-50 basis points. We see subsequent moves in September and December bringing the corridor to 75-100 basis points by year-end. (Given the FOMC’s convention of rounding the funds rate target up to the nearest quarter point, this would put our “shadow FOMC dot” at 100bp). Now that the public seems to be making its peace with the fact that rate hikes are coming, the question has increasingly become the pace of those hikes. We think the Fed can afford to stick with its plan the normalize rates gradually, at least initially. The first few hikes will involve some delicate issues for the plumbing of the interaction of the Fed balance sheet with the banking system, which should warrant caution. Moreover our economic forecast does not have enough inflation pressures next year to force them into a more aggressive tightening pace in 2015. We see a somewhat more aggressive pace in 2016, with the funds rate reaching 2.5% by year-end.