Fra BNP Paribas.
US FOMC: It’s all solid now
The FOMC raised the fed funds rate by 25bp, as expected, at its December meeting. Participants think that the likely tax changes will temporarily lift GDP growth and push the unemployment rate lower, although this boost appears to have no material effect on inflation, longer-run expectations for the economy or the appropriate level of near-term interest rates.
In line with our out of consensus view, and despite the pop in GDP growth coming early in the Fed’s forecast horizon, expectations for the appropriate level of the federal funds rate were unchanged until 2020, when the median expectation increased about 20bp to 3.06%.
This reinforces our call that the Fed will hike rates three times next year. In our view, this highlights a trend of what is likely ahead – a dovish Fed that will face a recession or create one.
The FOMC statement was broadly unchanged from the last statement (1 November) where the assessment of economic activity was upgraded to “solid” and the recent hurricanes were cited as a possible disruption to activity, employment and inflation.
This time around, the Fed upgraded its assessment of job gains to “solid” with a dismissal that hurricane related disruptions would have a material impact on their outlook. Two FOMC members (Evans and Kashkari) dissented, citing a lack of progress on inflation.
The Economy
- The Committee now thinks both economic growth and job gains are “solid”. This is an upgrade from the previous SEP meeting in September. Basically, they are saying the economy has strengthened even before the tax reform.
- The committee added 0.4pp to its forecast for 2018 growth and added another 0.1pp to 2019 and 0.2pp to 2020. Its longer-run estimate was unchanged at 1.8%.
- The median expectation for the unemployment rate was lowered 0.2pp throughout the four-year forecast horizon. It is now forecast to go as low as 3.9% in 2018, before moving 0.1pp higher in 2020 and ultimately rising to 4.6% in the long run.
- There were few adjustments to the outlook for inflation, both in terms of the statement or the committee’s projections. Inflation is forecast to accelerate to 2.0% in 2019 and remain there.
The Dots
- The dot plot of appropriate interest rates revealed no changes to the median dot for 2018 (it remains at three hikes), in line with our expectation.
- In fact, the 2018 dots were a bit dovish at the margin. The number of participants’ dots below three hikes grew to six from five in September, while the number of dots above three hikes moved to four from five in September. This may reflect Quarles coming on the committee and Fischer leaving.
- The median 2019 dot remained the same as well, continuing to imply two hikes for the year. However, the average 2019 dot increased, due mostly to the more hawkish participants raising their dots.
- The median 2020 dot was the lone one to move up, doing so by 20bp, implying about 1.75 hikes for the year. The long-run median dot remained unchanged at 2.75%.
- Averages moved up for all years (except the long run).
Policy Implications
In terms of policy implications, the statement and Summary of Economic Projections suggest no shift in stance over the immediate period ahead compared with what the committee envisaged previously – the median expectation is for three hikes in 2018 and two in 2019, as in the September SEP. That there was no change in the dots for 2018 and 2019, despite the growth forecast in 2018 being revised up by 0.4pp – is what we expected to result from inflation momentum being weaker than envisaged three months ago.
How much reliance can we put on this forward guidance given that the Chair and much of the Committee will change in 2018? Some, but the dots may be less than usually reliable. We see the statement as one emphasizing a likely continuity of policy between the Yellen and Powell Feds. That may not change until we get data surprises.
Where the policy outlook has changed a little is 2020, where the median dot is now for rates at 3.1% as against 2.9% in September and a long run estimate of neutral rates at 2.75%. The message is, therefore, that given the tax-stimulus to output, taking unemployment to below 4%, the Fed at some stage will have to take policy into restrictive territory, slowing the economy below potential in order to raise unemployment from the forecast low of 3.9% to the equilibrium level of 4.6%. The Fed, inevitably, will argue this can be achieved with a soft landing, but historically these are tough to come by.
Essentially, the Fed is telling us that the tax cuts increase the risks of a recession, despite being good for growth in the short run. Notably, there was no change in the median assessment of the economy’s long run growth rate – it stayed unchanged at 1.8%. The Fed, therefore, rejected the argument that the tax reform will noticeably change the rate of productive potential of the economy.
The fundamental message is that with inflation continuing to surprise on the downside, the Fed is willing to hike slowly and patiently, but that it increasingly accepts it will have to become restrictive at some stage. It currently does not envisage that happening until 2020. If inflation were to surprise on the upside, however, there is clearly scope to shift those expectations forward. In the light of today’s weak CPI, that does not look at all like an immediate prospect.
Another possible accelerator was mentioned by Yellen. If the labour market were to overheat, she said policy might need to adjust “abruptly” at some stage, jeopardizing the economic expansion. The FOMC expects the pace of job gains to moderate over time, and presumably the current dots are predicated on this. This hints at the prospect that the profile of the dots might shift forward if job gains stay strong and if the unemployment rate falls at a rate faster than they expect. Our forecast envisages their end-year projection of a 3.9% unemployment rate being hit in Q1 2018. Moreover, the unemployment has fallen by 0.5pp over the last year (and by 0.3pp in the last three months), when growth in 2017 is forecast to be lower than the 2.5% they envisage for 2018. In short, their unemployment rate forecast looks too high. Will the Powell Fed take the same view as Yellen outlined about a labour market that refuses to slow down? That remains to be seen, but the scene has been set for the Fed to shift gears if the labour market continues to race ahead.
