The FOMC preview from Societe Generale

Fed no longer patient, but by no means hasty

This week, the US will likely enter a new phase of the monetary policy cycle. We expect the FOMC do drop the “patient” language on Wednesday, which would mean that from June onwards every meeting is in play for a potential rate increase. At the same time, we look for the dots to drift slightly lower on the back of downside inflation risks, limiting any potential blow to financial conditions. We now expect only two hikes this year, one in June and one in Q4.

One can never be sure of anything, but we would put the probability of the Fed dropping the “patient” language above 95%. This will end an era of forward guidance and mark a shift to full data dependency. While nothing is pre-determined beyond this meeting, and Janet Yellen will offer no hints of when the next rate hike may be coming, we expect that the data will ultimately meet the conditions for a June rate hike. We believe that those conditions include further progress on the labor market, data consistent with above-trend growth, and confidence that inflation will return to two percent over the medium term. Importantly, the Fed is more concerned about the inflation outlook than about current inflation. To the extent that it views any weakness in core inflation as transitory, it should not constitute an impediment to lifting rates. We believe that a June liftoff would be appropriate as the labor market reaches full employment, but the low inflation environment – which largely reflects international developments – does allow the Fed to move less aggressively thereafter. As a result, we anticipate only one more rate hike this year, most likely in Q4.

In deciding the most optimal rate path, the FOMC has to consider not just the economic outlook, but also the impact of its actions on financial conditions and the risks associated with using an unproven exit toolkit. Market expectations for future policy rates are distinctly different from those projected by the FOMC. The gap, measured relative to the median FOMC forecast, currently equals 60 basis points as of year-end 2015; 110 basis points as of year end 2016; and nearly 140 basis points as of year-end 2017. Since the Fed defines its forecast as the “appropriate path of policy firming”, arguably it wants market expectations to converge to the “dots”, provided that the FOMC’s underlying economic forecasts come to fruition. However, this would almost certainly produce a significant shock to financial conditions. Spreading out the first two rate increases and picking up speed in 2016 should promote a more gradual repricing of market expectations.

Allowing a longer pause between the first and second rate hikes would also give the Fed ample time to test its new exit toolkit under non-zero rate conditions. While the new facilities – including the overnight reverse repo (ON RRP) – have been extensively tested over the pasttwo years, they may perform very differently once rates are lifted away from the zero lower bound. In the January FOMC minutes, participants noted that it is critical that the beginning of normalization is successful, i.e. that the effective fed funds rate trades inside of the new (0.25-0.5%) target range. They will not proceed with the second increase until they are fully in control of overnight market rates.

The FOMC’s median forecast for the fed funds rate currently (as of December) calls for four rate increases this year. Given our scenario, we believe that this will be revised down, most likely in a gradual fashion. This is easy to justify as the Fed’s near-term inflation forecast is also likely to come down. By dropping the reference to “patience” and beginning an orderly retreat on the “dots”, the Fed should be able to limit the market reaction and keep financial conditions broadly unchanged.