Markets face uncertainty on Federal Reserve hikes

As expected, the December meeting of the US Federal Reserve saw the central bank raise interest rates for the first time since June 2006 writes Oliver Mangan,Chief Economist atAIB.

The Fed announced a 25 basis point increase in the federal funds rate to 0.375%, ending a seven-year period where the rate was kept at 0.125%. The decision to hike was unanimous. The Fed was content to hike given that its two criteria for raising rates had been satisfied since its last meeting back in October.

Namely, a “further improvement in the labour market” and that it is “reasonably confident that inflation will rise over the medium term, to its 2% objective”. In her post-meeting press conference, Fed chair Yellen said that the decision to hike recognises the considerable progress that the economy has made.

She also provided further detail on the justification for why the Fed is increasing interest rates despite inflation being still very low-saying that the recent softness in inflation is transitory. She also explained that the Fed is cognisant that it takes time for monetary policy actions to affect future economic outcomes. The Fed does not want to be in situation where it delays raising rates for too long and ends up having to tighten policy relatively abruptly, which in turn could increase the risk of pushing the economy into recession.

At the same time though, both the Fed statement and Ms Yellen’s press conference remarks strongly emphasised that the pace of rate tightening is likely to be modest. The Fed expects economic conditions will evolve in a manner that will warrant only gradual increases in interest rates. Fed chair Yellen said it was likely that interest rates would remain below levels that are expected to prevail in the longer run for some time.

The members of the Fed Board provide projections on the likely path of interest rates. Their median projection for rates at end 2016 remained at 1.375%, while it was lowered slightly to 2.375% and 3.25% for end 2017 and 2018 respectively.

Overall, these projections are consistent with eight 25 basis point rate hikes from now until the end of 2017. Despite the Fed preaching about a gradual pace of tightening, it is still indicating a more aggressive path of rate increases than the market is expecting. Current futures pricing indicates that the market is looking for just two rate hikes by end 2016, taking the fed funds rate to 0.875%, well below the Fed’s projection of 1.375%.

Markets see rates at only 1.5% by end 2017, compared to the 2.375% Fed projection. Whether the actual path of tightening evolves as the Fed is currently projecting will depend on how the economy performs over the forecast period, in particular, the path of inflation. The Fed expects that its’ key inflation measure, the core Personal Consumption Expenditures deflator, will rise from 1.3% to 1.6% late next year and reach 1.9% in 2017 and 2% in 2018. US Treasury bond yields were largely unchanged in the aftermath of the Fed rate hike, while the dollar made some modest gains.

Nonetheless, it is clear that the market believes that there will be a much gentler path of rate increases than suggested by the Fed projections. The pace and extent of Fed rate hikes could well prove the key influence on financial markets next year. It would seem that the greatest doubts surround the Fed’s inflation projections. Given the strength of the dollar, subdued wage inflation and second round effects from lower energy costs, the core inflation rate may not rise to 2% as quickly as the Fed expects. In these circumstances, interest rates could well rise at a slower pace than projected by the Fed. This would be welcome news for all financial markets. However, if the Fed’s projections on inflation and interest rates prove correct, then there is likely to be a sharp sell-off on bond markets, with further gains by the dollar.

Stock markets could also suffer. We got a taste of this late last week when US equities fell sharply.

Source:Irish Examiner December 22nd 2015