Fra BNP Paribas:
The Fed raised interest rates 25bps in its December meeting, as widely expected, with its statement, SEP and press conference more hawkish than expected.
Three hikes rather than two were featured in the dot plot of expectations for the appropriate rate of Fed funds in 2017, after “some” participants incorporated potential fiscal policy shifts.
Inflation expectations were characterized as having moved up “considerably”, and Fed Chair Yellen qualified inflation expectations as “reasonably well anchored”.
The risks judgement being unchanged at “roughly balanced,” could suggest that the balance of risks has shifted from downside to upside. Chair Yellen notes that there may be some degree of labor market slack, but fiscal policy is not needed when unemployment rate is 4.6% — already a “modest undershoot” of the Fed’s long-run estimates.
The implication is that if a significant fiscal boost is legislated, the SEP forecasts for growth and inflation will likely be revised up further. The Chair highlighted that the median expectation in the Summary of Economic Projections (SEP) now envisages three hikes rather than two, which was described as a very modest adjustment, and reflected some participants’ incorporation of fiscal policy changes.
The fact that fiscal policy has not been factored in by all FOMC (or even by most) members implies that when policy changes are clearer further upward revisions will likely occur to projections for growth, unemployment and interest rates. The timing of this is unclear, but suggests that our forecast of two hikes for 2017 may be too cautious; the next rate hike could well come in June, giving three hikes in 2017.
Reacting to suggestions that the unemployment rate is already below the long-run rate and that this could indicate the Fed is already behind the curve, the Chair characterized the degree of accommodation as moderate and said that the Fed does not see a substantial undershoot of the unemployment rate below the natural rate and there did not appear to be extreme pressures in the labor market.
However, it is worth noting that while in November the statement referred to policy supporting a further “improvement” in the labor market, now it is seen to support “some” further “strengthening” in the labor market. This is a significant shift as further declines in unemployment were seen to be welcome previously, but now it sounds as though they could be tolerated, to a limited degree, but are not exactly welcome.
The Chair’s characterization of the labor market as essentially being where it was prior to the recession seemed to conflict with earlier speeches where she described it as remaining slack. With 4.6% unemployment, the degree of slack is diminished and fiscal policy is not needed to return to full employment; spurring productivity growth via fiscal policy would be beneficial, however.
Yellen was unwilling to speculate on possible policy changes by the Fed in response to shifts in government policy, unless she knew the specifics of the policies to be implemented. For example, whether productivity would be boosted and what this might mean for the neutral interest rate.
There was significant notice taken in the December statement of the rise in inflation expectations in the bond market, which were seen to have risen “considerably,” but are still judged to be low. During the press conference, the Chair said that inflation expectations were “reasonably well-anchored”. This sounds as though inflation concerns, of at least some of the committee, are starting to surface and may play a more important role going forward than they have previously.
