Will the Fed turn more dovish next week? For financial market participants, the answer seems to be a clear yes. We, however, don’t think so. Both falling oil prices and the ECB’s new bold QE programme strengthen, rather than weaken, the case for lift-off in Fed rates later this year, in our view. The Fed will probably applaud the ECB’s move, even if it implies further strengthening of the USD.
With markets increasingly gripped by fears of global disinflation and economic stagnation, financial market participants have pushed out expectations for the first Fed rate hike to the end of this year. Thus, according to the fed funds futures contracts, the first 25 bp hike will be in November.
There is little evidence, however, that the Fed has altered its plan to start raising rates around mid-year. Hence, we expect next week’s FOMC statement to indicate that the Fed remains on track to start raising rates around mid-year.
The FOMC statement will be released on Wednesday at 20.00 CET. There is no press conference after the meeting, and no projections will be released.
In December the Fed took a small step towards its first rate hike in nearly a decade, when rather than saying it would wait a “considerable time” before raising rates it said it would be “patient” – a term Fed Chair Yellen suggested meant it might move in April at the earliest. With a 1.125% median FOMC projection for the fed funds rate by end-2015 and an assumed 25 bp of tightening per FOMC meeting, the Fed’s December projections pointed to the first rate hike in July.
Still, the Fed is likely to repeat in its post-meeting statement on Wednesday that it can be “patient” about rate increases. According to the December FOMC minutes, the reference to patience indicates that the Fed is unlikely to begin the normalisation process for “at least the next couple of meetings.”
Thus, if the Fed is to raise rates by June, as we forecast, it should signal it by removing “patient” from the March FOMC statement. We continue to see the fed funds rate at 1.25% by end-2015 and 2.50% by end-2016, close to the median FOMC projection of 1.125% and 2.50%, respectively.
Lower inflation not a game-changer, at least so far
The downward push to inflation from falling oil prices and a stronger USD is not a game-changer for the Fed. Yes, even core CPI inflation slowed recently, to 1.6% y/y in December from 1.7% in November and 1.8% in October. But in December Fed Chair Yellen said that while cheaper oil “may spill over to some extent to core inflation, we see these developments as transitory.” As we read the December CPI data, there were signs of a spill-over from lower oil prices to core CPI.
Also the December FOMC minutes downplayed the impact of falling oil prices and the stronger USD on inflation: “With lower energy prices and the stronger dollar likely to keep inflation below target for some time, it was noted that the Committee might begin normalization at a time when core inflation was near current levels, although in that circumstance participants would want to be reasonably confident that inflation will move back toward 2 percent over time.”
From the Fed perspective, falling oil prices might actually have strengthened, rather than weakened, the case for raising rates later this year. Thus, the substantial decline in oil prices will probably imply an upward revision to Fed officials’ GDP growth forecasts at the next revision in March. For more analysis.
Foreign economic outlook now less of a concern
In the wake of the ECB’s decision yesterday to launch a major QE programme, the Fed is unlikely to signal concerns about the foreign economic outlook next week. Already in December such concerns were somewhat downplayed because the likelihood of further responses by foreign central banks had increased. Now the ECB has delivered and the Fed will probably applaud this move, even if it implies further strengthening of the USD.
What would cause the Fed to change its plan?
If the disinflationary pressures are sustained, the Fed might eventually change its plans to begin normalising monetary policy around mid-year. Thus, if we continue to see no clear evidence of a broad-based acceleration in wages, the Fed will probably wait until September before raising rate.
The Q4 employment cost index (ECI) released on Friday will likely be very important for the timing of the first rate hike. The NFIB and JOLT surveys released last week point to more upward wage pressures.