The Federal Reserve is almost certain to increase the target range for its Fed funds rate again in the US on Wednesday, in what we think could be the first of as many as four 25 basis point rate hikes in the country in 2018.
Financial markets are now fully pricing in another rate increase following a string of recent hawkish comments from a number of FOMC members, including newly appointed Chair Jerome Powell. Powell, who was sworn in to replace Janet Yellen as the new head of the central bank in February, struck a very hawkish tone during the semi-annual testimony to Congress in Capitol Hill last month. Powell claimed that headwinds to the growth outlook had ‘turned into tailwinds’ since December. He also issued a warning that the Fed would not let the US economy overheat and signalled that it remains on course to raise rates on multiple occasions this year.
With Fed fund futures currently placing a 100% probability of a rate hike when the bank meets on 21st March, the US Dollar will instead take its cue from the tone of communications in Jerome Powell’s press conference and, arguably more significantly, the Fed’s updated ‘dot plot’. We think that a number of factors since the December FOMC meeting, when the bank last hiked rates and released its quarterly economic projections, could mean that we see a modest upward revision to the bank’s interest rate forecasts.
Firstly, Donald Trump was finally able to force through his long awaited tax cuts in late-December, which many believe could lead to a faster pace of growth in the US this year. These tax cuts, which include significantly lower corporate rates, could add as much 0.5% to overall GDP in 2018 according to analysts. Rising trade tensions present somewhat of a risk to the outlook, although we do not think this will have any meaningful impact on the Fed’s hike projections.
Secondly, the US labour market has also gone from strength to strength. Jobless claims are near 50 year lows, the unemployment rate is at its level lowest since 2001, while net job creation jumped above 300,000 for the first time in over a year-and-a-half in February. Average earnings growth has also increased and is currently comfortably above the level of core inflation (Figure 1). It will be interesting to see whether the Fed makes any comments on full employment, the estimated level that the jobless rate cannot fall below without creating inflationary pressures. So far, the sharp decline in the jobless rate to 16 year low levels appears to have had only a very modest impact on wage growth.
Figure 1: US Average Hourly Earnings (2011 - 2018)
Source: Thomson Reuters Datastream Date: 16/03/2018
The FOMC’s December ‘dot plot’, which represents where each member of the committee expects rates to be at the end of each year, showed that policymakers anticipated a median of three rate hikes in the US this year. We see a reasonable chance that the aforementioned improvements to the outlook could mean that this median is revised upwards to four hikes in 2018, with three to four hikes pencilled in for 2019. This would be a significantly faster pace than the market is currently pricing in. Despite increasing in the past few months, Fed fund futures are only placing around a 25% chance of at least four rate increases in the US this year (Figure 2).
Figure 2: FOMC Implied Rate Hike Probability (December ’17 - March ’18)
Source: Bloomberg Date: 16/03/2018
Overall, we expect the Fed to adopt a hawkish tilt in Jerome Powell’s first meeting as the new Chair. It will likely continue to emphasise the strong labour market and that inflation should stabilise around the 2% target in the medium term. Rhetoric on the effect of Trump’s tax cuts and protectionist policies on overall activity will be heavily scrutinised, although we think that the Fed will reiterate that risks to the outlook are ‘roughly balanced’. As mentioned previously, we also see a good chance of an upward revision to the ‘dot plot’ to show an average of four interest rate hikes in 2018. We think that an upward revision to the hike projections would take some of the market by surprise and could lead to a fairly sharp upward move in the US Dollar in the immediate aftermath of the announcement.
In our view, FX markets are continuing to place too much emphasis on the growth surprise in the Eurozone and not enough on the widening in rate differentials between that of the Federal Reserve and the European Central Bank. A concrete signal from the Fed that it may be ready to hike more aggressively than previously anticipated would widen these rate differentials and we believe could recommence a gradual recovery in the US Dollar against the common currency.