The Federal Reserve remains firmly on course to raise interest rates for the third time in the calendar year at its December meeting this week as it continues on its gradual path of monetary policy normalisation.
Following another impressive few weeks of economic data in the US and a generally hawkish tone of communications from a number of senior rate-setters on the FOMC, Fed funds futures are placing almost a 100% chance of a rate hike on Wednesday. At its most recent meeting in November the Fed held rates steady at a range between 1-1.25% while striking a hawkish tone on a strengthening labour market. It also stated that economic activity had been rising at a solid rate despite hurricane-related disruptions. Outgoing Chair Janet Yellen struck an equally upbeat note on the state of the US economy during her recent appearance in front of Congress at her semi-annual testimony.
Recent impressive economic news all but guarantees a rate hike from the Fed. The US economy expanded by an upwardly revised 3.3% annualised in the third quarter of the year, its fastest pace of growth in three years. In the third quarter of 2017, robust domestic demand was further buoyed by a strong expansion in business investment. Last week’s labour report was also broadly encouraging. The US economy created an impressive 228,000 jobs in November following on from October’s 13 month high 244,000. Earnings growth was a little disappointing, although wages still expanded last month and on an annual basis hourly wage growth rose back to a still healthy 2.5%, comfortably above inflation.
With a 25 basis point increase in the Fed funds rate almost assured, the US Dollar will take its cue from the tone of communications and the release of the latest ‘dot plot’, which should give us a clearer indication as to the pace of additional tightening in 2018. We think that the statement and Yellen’s speech will remain upbeat, acknowledging both the rebound in the labour market following September’s hurricane induced slump and an increased confidence that inflation will return to target over the forecast period.
As for the ‘dot plot’, which represents where each member of the committee expects rates to be at the end of each year, we don’t expect much change from the Fed’s September meeting. In September, the median projections showed that the FOMC expects to hike on approximately three occasions next year, in line with their expectations for higher inflation. Headline inflation is now back above 2% again, while core consumer price growth increased back to a six month high 1.8% in October (Figure 1), just shy of the Federal Reserve’s target. It is worth noting that the more hawkish Randal Quarles will replace outgoing policymaker Stanley Fischer on the board for the first time this month, which could potentially contribute towards a somewhat higher median rate forecast for 2018.
Figure 1: US Inflation Rate (2013 - 2017)
Source: Thomson Reuters Datastream Date: 08/12/2017
In addition, since the October meeting the Republican-controlled Congress has come very close to passing a tax bill that entails significant reductions in corporate rates. In the short term, this entails a net stimulus to the US economy of about 0.5% of GDP in 2018 alone. Fed officials have repeatedly expressed their dislike of this ill timed stimulus, and suggested the rates will rise more than they would have otherwise as a result.
An indication from the Fed that three rate hikes are still likely in 2018 should cause more investors to bring forward their expectations for the next hike into the first quarter of next year. We think risks to the US Dollar going into the meeting are slightly skewed to the upside. Financial markets are still under-pricing the pace of hikes over the forecast period in our view and there is still a clear disconnect between market expectations for future hikes and that of the Fed (Figure 2).
Figure 2: FOMC ‘Dot Plot’ September 2017 (2017 - 2020)
Source: Bloomberg Date: 08/12/2017