Tuesday 20 March 2018

Dollar strengthens as the Fed hikes for the first time in over 9 years and signals more to come

Federal reserve building, Washington DC. USA.
Federal reserve building, Washington DC. USA.

Simon Barry, Chief Economist, RoI

After months of lead‐in and following what has felt at times like a Godot‐like wait, the Fed finally took official interest rates in the US off the zero bound last night, raising the fed funds target range by 25bps to 0.25%‐0.50% ‐ the first rate hike in the US since mid‐2006.  The extensive post‐meeting communications (including the regular trio of policy statement, updated economic projections and a post‐meeting press conference) made clear that the decision to hike was based on the combination of considerable improvement in the labour market to date in the recovery alongside a reasonable level of confidence that inflation will rise to 2% over the medium term.  In other words, given the significant progress which the economy has made in getting itself back to something approaching normal operating conditions, it is now appropriate to begin the process of getting interest rate settings back towards more normal levels.

The Fed’s updated economic projections reveal a slight upgrade to the economic outlook for next year, with the median estimates for GDP growth and the unemployment rate each marked stronger by 0.1%, to 2.4% and 4.7% respectively.  While the size of these revisions is very small the direction of change reveals slightly stronger confidence in the 2016 outlook for the economy among policy makers.  But, in keeping with a familiar theme, the outlook for year‐ahead core inflation has been revised a touch lower, with the core PCE measure now seen at 1.6% in q4 of next year (from 1.3% on the latest estimate).  Yellen’s press conference emphasised that the key driver of future Fed policy will be a rolling assessment, importantly informed by incoming economic news, of how the economy’s outlook is evolving relative to those expectations.  Based on its current assessment “only gradual increases” in rates will be warranted, and further, official rates are likely to “remain, for some time, below levels that are expected to prevail in the longer run” (which the Fed currently thinks is around 3.5%). 

Gradualism was a strong and recurring theme of the Fed Chair’s message last night, with Yellen pointing out that commencing now and continuing at a gradual pace would help avoid a scenario whereby the Fed might need to act more “abruptly” later.  So what does gradualism mean? Well, the median view among the Committee is for 1% of tightening next year (unchanged from September).  That would correspond to exactly half the pace of tightening that was delivered in the first year of the last cycle when rates were raised by 0.25% at each Fed meeting over two years.  Yellen refused to be drawn on the timing of possible hikes next year, emphasising that policy will be driven by that data‐dependent rolling assessment we noted earlier and not by a predetermined set path.  While some members of the investment and financial media communities may feel it unsatisfactory that there isn’t more precision to current Fed guidance, the reality is that Yellen’s comments and approach merely reflect the inherent uncertainty of economic forecasting and policy formulation.  That is, after an exceptional period of crisis‐management where the Fed (and other central banks) proactively engaged in parameterised forward guidance,yesterday marks a return to a more regular and conventional approach to policy making at the Fed that has data dependency at its core.  If anything, given solid trends in the labour market and domestic spending, we sense a slight skew towards incoming inflation news as a particularly important point of focus for the Fed in the period ahead.

The initial market reaction has been pretty much in line with our expectations.  In particular, we have seen some mild upward pressure on US market interest rates and short‐end bond yields.  Notably, 2‐year bond yields have risen by about 3bps over the past 24 hours to take them above 1% for the first time in over five and a half years.  That’s up from as low as 0.55% as recently as mid‐October.  In turn, the continued upward drift in front‐end US rates is contributing to a modest strengthening of the dollar, with the greenback up 0.8% against the euro to open at $1.0870 this morning.  And in risk asset markets, US stocks also had a positive reaction to last night’s developments, with the S&P closing out the session with gains of close to 1.5%.  So all told, the Fed will be pretty satisfied with the early outcomes here, as the choreographed lift‐off has indeed gone smoothly without triggering any major volatility in markets, helped by the emphasis on gradualism as a key feature of the coming hiking cycle. 

We continue to expect the delivery of a cycle of gradual rate hikes in the US to be associated with further downside for Eur/USD, and continue to target sub $1.05 in the weeks and months ahead. While the main focus for investors has been the FOMC meeting, it was not the only game in town yesterday as we also got some important data releases on this side of the Atlantic. In the UK, the employment data highlighted further ongoing improvement in the labour market, with employment posting greater than expected gains of 207k in the three months to October. However, the report showed no signs of this improvement translating to sustained upward wage cost pressure as growth in average weekly earnings (ex. bonuses) slipped from 2.4% y/y to 2.0% y/y in the three months to October. In the Euro Area, the flash PMI release indicated that the composite PMI edged slightly lower in December, from 54.2 to 54.0. However, the PMI remains at levels consistent with relatively healthy quarterly growth of 0.4‐0.5% q/q, broadly in line with ECB forecasts. 

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