Monday, December 12, 2016

FOMC Report December 13-14, 2016; New Fed Regime Party - 2nd Annual Policy Rate Normalization


The Federal Reserve is expected to raise its fed funds policy rate by 25 basis points at the upcoming December FOMC meeting.  To do otherwise at this point would cause confusion and reduce the near term prospects for growth.  Solid employment growth and more recent modest improvement in inflation conditions allow the Fed to move policy rates in accordance with its dual mandate objectives.  Still, the Fed is likely to be overly cautious in providing a message that the policy rate hike at this meeting is not expected to be followed by a series of such moves anytime soon. 

The last time the Fed raised its policy rate was a year ago and it has been since late 2007 that the Fed has made similar sized consecutive policy rate adjustments at regularly scheduled meetings.  Before last year, the last time the Fed raised policy rates was in June of 2006 and that too was 25 basis points.  June 2006 concluded 17 successive 25 basis point policy rate advances at consecutive meetings.  Following that scale of adjustments at the current annual pace would put fed funds at 4.5% in 2032.  Laughable maybe, but the message in the December FOMC meeting statement and that of Chair Yellen in post-meeting press conference will offer guidance closer to the latter pace of policy adjustment than the former.   

This slow move toward ‘normalizing’ policy is in line with the Fed’s determination to respond to the flow of economic data, which to date has prevented a more accelerated pace of that normalization.  The nature of recent domestic political change further allows the Fed to offer watchfulness as their immediate overriding interest rather than a concentration on the timing of additional policy application.    

Potentially A Long Awaited Growth Surprise
It has been pointed out many times over the last years that household balance sheets have repaired since the financial crisis and that these repairs were reason to expect a renewal of consumer spending, fulfilling a long-suppressed and pent-up demand.  Commercial interests too, with long-friendly financial conditions though absent consumer spending, were seen as at the cusp of greater capital investment once consumers opened their purses.

Instead, consumers, business leaders and therefore the Fed have been given successive, though sporadic reasons to delay any appreciable movement toward ‘normal’ or standard operating procedures.  Yet today, following a largely surprising political development, a shift in asset prices, which can only be read as movement toward pricing greater prospects for economic growth and possibly inflation pressure is under way.  Clearly there are those who would surmise the policies directed from a Trump White House and enacted in a Republican controlled Congress can boost economic growth in the near term.
 
On the back of recent political developments a modest minority have already engaged themselves in more elevated risk profile.   There is a much greater majority that is expected to become thus involved should a collection of data points over the coming months prove convincing that a stronger risk appetite is paying handsome dividends.  There will be a not so insignificant minority, who for absolute distaste in recent political developments alone, will refrain from actively engaging any bullish projections until a much later date.  It is the make-up of this dynamic rather than by virtue of particular political figures or their mandates which are expected to give any renewed growth prospects significant potential and help to create the very growth that has been absent these last years.   

Well before recent political developments, economic agents had priced greater than even odds for a rate hike before year end.  Expectations for that same small adjustment have become nearly unanimous as the market has reacted to events by adjusting Treasury yields higher in November by more than it has in any one month since 2009.  Higher long term Treasury rates have generally been interpreted as indicating expectations for stronger growth and greater inflation. 

Lately, Fed officials have more generally looked with favor on higher longer term Treasury yields and a steeper yield curve to the extent these point toward improved economic prospects, while benefiting the profitability of the banking system and therefore possibly its stability.  However, rates have risen sharply enough over the last month that the FOMC post-meeting statement is not expected to encourage any further steepening of the yield curve or substantial rise in US Treasury long rates.  Instead, the Fed will likely indicate that policy remains somewhat accommodative and that the prospect for growth and inflation, though uncertain, are roughly balanced. 

Finally, the Summary of Economic Projections (SEP) is expected to remain relatively unchanged with modest upward adjustment to employment, inflation and economic growth prospects in this and the next two years.  Real GDP projection expected higher by 0.2% to 2.2% for 2017 and 2018.  A lower projected unemployment rate (from 4.8% year end in September to 4.6-4.7%) is expected given the recent drop in November to 4.6%.  Otherwise, a modest 0.1% increase in expected Core PCE inflation is a possibility for this year and next (to 1.8 and 1.9% respectively).  The Fed policy path projection is not expected to change at this meeting.           

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