The FOMC meeting on 16-17 December is due to conclude with a policy statement and updated economic projections, followed by a 45-minute press conference. The FOMC is likely to revise down its unemployment and inflation projections for next year but more interesting will be changes in the dots reflecting individual members’ projections of the Fed funds rate.
While core inflation keeps running below the Fed’s 2% target, the labour market continues to improve and the November employment report was solid, with indications that wage growth is also picking up. Although inflation expectations have continued lower, we believe the Fed largely attributes this to the current decline in gasoline prices and does not see it as very worrying. In general, the recent run of economic data has been strong but, despite this, money markets continue to price a very dovish Fed funds rate path.
NY Fed governor William C. Dudley has said that pricing a first Fed funds rate hike around mid next year is consistent with the FOMC’s projections. This raises the question of when the FOMC will change the statement to signal that rate hikes are moving closer. The key phrase in the forward guidance states that it likely will be appropriate to maintain the 0.0 to 0.25 percent target range for the federal funds rate for a considerable time....
Looking back to the hiking cycle that started in June 2004, there are several similarities to the current situation. In January 2004, following seven months of unchanged fed funds rate, the FOMC changed the statement wording from the Committee believes that policy accommodation can be maintained for a considerable period to the Committee believes that it can be patient in removing its policy accommodation. The first 25bp rate hike came in June 2004, six months later.
The fear of a significant market reaction, which could be a risk if the market translates the removal of considerable time into meaning a rate hike in six months as in 2004, is the main reason the Fed may opt not to move in December. However, Fed Chair Yellen has plenty of time to explain that patient does not necessarily mean six months and that any rate decision is data dependent.
We thus expect the FOMC to replace considerable time in the statement released on Wednesday but put a 20% probability on it waiting. It might not use the exact same phrase as in 2004 but, in our view, the meaning will, in essence, be the same as patient in removing the policy accommodation.
In terms of markets, the US money market curve is extremely flat compared with the FOMC projections of the Fed funds rate path. Currently, the market is pricing only slightly more than one rate hike by the end of next year and a first hike around September/October. Although Fed Chair Yellen is likely to make it clear that there is no set timetable for a first rate hike, taking away considerable time nevertheless brings us one step closer to the initial rate hike.
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