Fed’s decision key takeaways
The Federal Reserve raised its benchmark interest rate by 25 basis points on Wednesday to a target range of 1.25%-1.5%. The central bank also expects higher economic growth from 2018 to 2020 compared to September’s projections. They now expect GDP to grow 2.5% in 2018 from 2.1% forecast in September, and 2.1% in 2019 from 2.0%. However, longer term growth expectations were left unchanged at 1.8%, suggesting that tax reforms will only have limited impact on the economy. On another positive note, the Fed expects the unemployment rate to fall to 3.9% in 2018 and 2019, from an earlier forecast of 4.1%.
Despite the interest rate hike and the upgraded economic growth projections, the dollar fell instead of rising. Here’s why:
• The Fed remained concerned about inflation which continued to undershoot its target. This led to two policymakers Charles Evans and Neel Kashkari dissenting against the decision to tighten policy.
• Many economists expected that tax reforms would lead to higher interest rates in 2018, and 2019. However, the Fed’s Dot Plot remained unchanged- projecting three rate hikes for 2018 and two for 2019.
• The sharp fall in Treasury bond yields suggests that investors were expecting more hawkishness from the Fed, particularly in terms of interest rates projections for 2018.
Given that Charles Evans and Neel Kashkari, the current voting members, will be replaced by Loretta Mester and John Williams next year, we are likely to see a more hawkish Fed. However, it won’t be until March 2018 that we get additional guidance from the Federal Reserve which will be led by the new Chair Jerome Powell.
ECB and BOE
The European Central Bank and Bank of England are due to announce their last monetary decisions for 2017 later today. While no significant changes are expected in terms of interest rates or asset purchases, markets could still move with the publishing of ECB’s new economic forecast.
Given that the ECB cut its asset purchase program in October to €30 billion from €60 billion, I don’t expect anything new on this front. However, the Eurozone’s economy has seen broad improvement in many key economic indicators. GDP growth, employment, retails sales, consumer confidence, manufacturing and services PMI, and core consumer prices, all improved from the last meeting. This should be reflected in the staff’s forecast on GDP growth and probably inflation. Draghi’s tone however, will be the key driver for the single currency. Despite the improvement in data, his tone has remained dovish for the past couple of meetings. Any hawkish surprise will lead to strength in the Euro, as it signals a shift in policy for 2018.
The BoE will continue to be overshadowed or influenced by Brexit talks. Theresa May’s defeat yesterday, in a key vote which gave the Parliament a legal guarantee to vote on the final Brexit deal with Brussels, will likely complicate the BoE’s view on Brexit. However, the improvement in economic data and a surge in inflation above 3% might pressure the central bank to tighten policy further in 2018. Any hints of rate hikes next year will boost sterling, although I expect more information will be provided in February 2018 when the BoE updates its economic forecast.
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