After ECB’s Hawkish Cut, Is The Fed About To Deliver A Dovish Hike?

After much hemming and hawing since mid-year, the Federal Reserve is finally poised to raise rates for the first time in nearly a decade. Indeed, given the speeches by the leadership and the economic data, especially the labor market readings, the failure to raise rates would likely be more destabilizing at this juncture than lifting them.  

Surveys of market participants suggest that a Fed hike is as done of a deal as such an event can be. A recent Reuters survey found all but one primary dealer expects a hike this week. A Wall Street Journal poll found 97% of professional and academic economists also expect the Fed to raise rates this week. That is a five percentage point increase from last month and 10 from October.  

It appears that many are looking past the decision itself. The FOMC statement’s economic assessment is unlikely to change very much. The economy is performing largely in line with its expectations. In this context, we note that after retail sales and inventory data, the Atlanta Fed’s GDPNow tracker has Q4 GDP expanding at 1.9%, up from 1.5% the previous week. This is generally thought of as trend growth for the US, given the slower productivity and labor force growth.  

The Fed has been at pains to drive home two points to investors. First that the pace of rate increases is expected to be gradual and dependent on the evolution of economic activity. In September, gradual was operationally defined by the dot-plots as 25 bp a quarter (every other meeting) in 2016 and 2017. The market will be looking at the new forecasts to see if this is still the Fed’s thinking. A few investments houses, and Fitch, the rating agency, have also forecast four hikes next year.  

The second point Fed officials have stressed, and will likely to be repeated at the end of the new FOMC statement, is that the terminal rate or the peak in the Fed funds target will probably be lower than in past cycles. Again, the dot-plots suggest that officials expect the Fed funds to peak near 3.75%. The market, as reflected in the Fed funds futures and OIS market expects considerably lower rates.

In the past, the real Fed funds (adjusted for inflation) had to be near zero or below before the US economy recovered from a recession. In this expansion, the market does not expect Fed funds to be positive in real terms. The implied yield of the December 2016 Fed funds futures contract is 77 bp. The Dec 2017 contract implies 127 bp and June 2018 is at 147 bp.  

A significant challenge to using the Fed funds futures contracts to interpolate expectations of Fed policy is that the contracts settle at the average effective rate for the month, not the policy rate. Now that Federal Reserve has adopted a target range for the Fed funds rate, the it is an open question of where Fed funds will average after a hike. At the zero-bound (current target range is 0-25 bp), the Fed funds have averaged around the mid-point of the range 12-13 bp. 

What Fed funds average after lift-off is an open question. Many popular models simply assume that the midpoint achieved on average. However, to drive home the point of gradual hikes, and to maximize the attractiveness of interest on excess reserves, which did not exist before the crisis, suggest the risk sufficiently liquidity is provided by the Fed to keep the funds rate on the soft side of the midpoint.  

The Fed’s dot-plots, which we argue, has a high noise to signal ratio, may be particularly important this week to help shape expectations of the next hike. Bloomberg calculates that the March Fed funds contract are implying about a 35% chance for a second hike. The Wall Street Journal polls found nearly 2/3 (65%) of the private sector professional economist expect the Fed to deliver the second hike in March. In November, only half (49%) expected a March hike. Another 14% expect the second hike to be delivered April (when the FOMC meeting is not accompanied by an update in forecasts or a press conference).