Fed Watch: Shifting Dots

Tim Duy:

Shifting Dots, bt Tim Duy: The Federal Reserve begins its two-day meeting today. The outcome of the meeting is no longer in debate. A 25bp rate hike is widely expected after a round of Fedspeak in the week prior to the blackout period and the February employment report. More important now is what signal the Fed sends with the statement, the press conference, and the dots. I anticipate the overall message to signal general confidence in the economic outlook while reinforcing the idea that the Fed is neither behind the curve nor intends to fall behind the curve. The combination will give the Fed room to tighten policy at a gradual pace. I think that four hikes this year would still be considered gradual from the Fed’s perspective. After all, the expectation of four hikes a year was considered gradual at the beginning of 2016. Not sure why it shouldn’t be considered gradual now. 

At the end of last year, the Fed’s median interest rate projection anticipated 75bp of rate hikes in each of 2017 and 2018. That translated into my 2017 baseline of two rate hikes with an option on a third, basically including a bias to account for the fact that the Fed’s forecast has fallen short in recent years. If economic conditions were such, however, that the Fed pulled forward the first hike to March, I said that my expectation would shift to a baseline of three with an option on four. What that means, in effect, that I expect the dots to shift upward to reflect an anticipation of four rate hikes in 2017.

With March likely, will the dots move as I expect? Not everyone thinks so. Morgan Stanley, for instance, expects the dots will show higher rates in 2018 and 2019 instead. Via Business Insider:

 So why do I think it is more likely than not that the Fed raise the dots for 2017? Consider first the projections for output growth, unemployment, and inflation. Those should play directly into the rate hike forecast in a systematic fashion. So it you think the odds favor some combination of a higher expect growth gap (the difference between actual and longer run output growth), a lower than anticipated unemployment gap (the difference between actual and longer run unemployment), and a higher inflation forecast, then you should anticipate the dots will shift upward. 

In practice, of course, these estimates depend in part on the Fed’s estimate of potential growth and the natural rate of unemployment. I don’t think either has likely change, so the relevant factors should be the forecasts of the actual variables. Overall, I think it reasonable to believe that at least one, and likely two factors will point to higher rates.

Second, the Fed clearly believes that the balance of risks has tilted at least to completely balanced if not toward the upside. External risks have waned, incoming data both soft and now, with the employment report, hard have been solid, and Fed officials are captured by the allure of fiscal stimulus. FOMC participants whose rate forecasts incorporated a heavy downside risk (reasonable given what happened in 2016) will likely pull their rate forecasts up in a sigh of relief. In essence, these members will believe that without pulling forward rate hikes, they will be in danger of overshooting their targets.

Third, the financial markets were particularly buoyant in recent months even as expectations of tighter policy intensified. I think some FOMC members – yes, New York Federal Reserve President William Dudley, I am looking at you – will want to push back on those easier conditions in the name of financial stability. So that argues for pulling rate hikes forward.

Fourth,  estimates of the longer-run natural rate could rise. I don’t anticipate this, as I don’t see they have evidence to suggest this is the case, but I did not anticipate the small bump upward in the neutral rate estimates in the December Summary of Economic Projections. 

Altogether then I see more reasons likely to raise the 2017 rate projections than to hold them steady. Hence my expectations for the dots to nudge upward. Basically, it just puts the Fed back to where they started in 2016, expect with more cause to believe it will actually work out this time.

Of course, the rate projection is not a promise, and given recent history I tend to shade down my expectation from what the Fed projects. Hence my three with an option on four. I also am not entirely sure how they will integrate balance sheet reduction with rate hikes? Do they announce a balance sheet reduction at the same meeting they raise rates? Or do they pass on a rate hike to announce a balance sheet reduction? It seems like they would what to avoid the latter because it would equate the balance sheet tool with a rate hike a little too directly. Instead, I expect they would want everyone to think the balance sheet reduction is no big deal. So that argues for both at say the September meeting and that then places an option on the December meeting. If would be nice to have better guidance on this issue.

I tend to think the balance sheet issue is another reason to front load hikes in 2017 if possible. Then they have room to pause in 2018 if balance sheet reduction is a bit sloppier than anticipated.

Bottom Line: I see more reasons that not that the Fed will push up its 2017 rate hike projections. Lots of different factors – external, data flow, fiscal stimulus, and financial conditions – to say that with the economy hovering near potential output, the time is right to make a slightly faster move toward the neutral rate. Indeed, I have a hard time seeing why they would pull forward a rate hike if they weren’t trying to create room for an additional hike this year. Note that this would really be just moving the ball down the field a bit quicker, not changing the goal posts – the estimate of the neutral rate. A higher estimate of the neutral rate would be much more hawkish than just quickening the pace slightly to that rate.