December Meeting, US Interest Rates and Rate Projections

At the December meeting, the Federal Open Market Committee followed through on their well-telegraphed intention to hike rates in 2016. The decision was unanimous. Although the rate increase was expected, there were some additional hawkish surprises in the economic projections. Most importantly, the median rate projections increased to reflect three hikes, rather than two, in 2017. The near-term median projection for GDP growth increased slightly, and the median unemployment forecast ticked down for 2017. Some of these hawkish shifts were likely a response to improving data, but the election may have played a role as well. In the press conference, Yellen suggested that some (but not all) participants “did incorporate some assumption of a change in fiscal policy into their projections.”

However, the longer-term framework for the FOMC appears unchanged after this meeting. Forward guidance in the statement continues to point to “only gradual increases in the federal funds rate.” Moreover, the press conference and economic projections reiterated the view that the neutral rate is currently low, suggesting a hiking cycle is expected to be limited. In the press conference, Yellen stressed the “considerable uncertainty” around new economic policies. However, she also expressed some skepticism about the value of stimulus, noting that “fiscal policy is not obviously needed to provide stimulus to get back to full employment.” Moreover, she pointed to some risks of loose fiscal policy, including an elevated debt-to-GDP ratio and the possibility of inflationary overheating. On two occasions, she backed away from her recent speculation that “running the economy hot” may be beneficial to undo some of the long-term negative effects of the recession. Interestingly, in response to a question about her career plans, Yellen refused to rule out that she might stay on the Fed Board of Governors after her term as Chair ends in 2018. It is highly uncommon for an ex-Chair to remain on the committee, but Yellen is technically entitled to serve as Governor until 2024, diluting the FOMC voting power of Trump appointments. Overall, the outcome of the December meeting is slightly hawkish. However, beyond ordinary data dependence, the Fed is also likely to be reacting to the emerging economic policies of the Trump administration. We continue to expect two hikes in 2017, at the June and December meetings, but the outlook is liable to shift considerably in the months ahead.

Markets have interpreted yesterday’s FOMC meeting as hawkish, and interest rates across the curve have repriced higher. How hawkish was the Fed? We don’t think a lot, and while we agree with the levels to which markets have repriced, we are surprised by the pace at which it happened. Indeed, we think it is hard for markets to price in more than the 2.5 hikes currently priced in for 2017 without further evidence of accelerating inflation or the massive and much talked about Trump stimulus materializing. We’re skeptical that we’ll see early evidence for either, but it isn’t something we can entirely rule out either.

While we don’t think there’s much room to price additional hikes in 2017, we believe there’s room for some additional hike pricing in 2018. Markets are currently pricing about two hikes, but given that 2018 is the first year when we expect fully ramped up deficit spending, we suspect there’s room for more. Of course, there’s the risk that a Trump Fed will mean a more pliant Fed that’s less keen to hike even in the face of inflationary pressures, but this risk is somewhat unclear at this point. Further, should Yellen stay on at the Fed after her term as Chair ends in January 2018 – a possibility that she left open – it would likely reduce this risk somewhat (while her term as governor ends in 2024, it is highly unusual for and ex-Chair to remain on the Committee). As a result, we expect that there is some further steepening to go in whites/reds or whites/greens, though absent strong uptrends in inflation readings, the extent of this steepening could be limited.