At its 26 September meeting the Fed hiked rates and signaled a continuation of its gradual tightening path.
The FOMC’s decision to hike the federal funds rate by 25 bps to 2.0-2.25% was fully anticipated by the market, nor was it a big surprise to see the 'dot plot' unchanged. What was more interesting was the change in the Fed statement. Removing the phrase “the stance of monetary policy remains accommodative” that had previously been used, was seen as a slightly surprising and dovish move – they could also have waited until a later meeting to do this.
Chairman Powell explained that taking the phrase out now, while rates are "obviously still accommodative", would prevent the Fed from having to change the statement at a later stage when it could be regarded as a more important signal. According to Powell, the Fed also wants to avoid sounding overconfident on what the exact level of the neutral rate is. FOMC members estimate this neutral rate – the interest rate level that neither stimulates or restrains economic growth – is somewhere in the range between 2.5 and 3.5%.
When questioned on topics such as inflation being sticky, or the possible negative effects of the trade war with China, Powell stuck to his preference for a 'wait-and-see approach', which he also expressed during the Jackson Hole conference. When discussing the continued modest (2.0-2.1%) inflation outlook in an environment of record low unemployment, he noted that we are "living in a world of strongly anchored inflation expectations".
In the closely watched ‘dot plot’, the FOMC members express their view on official rates for the coming years. Their expectations have hardly changed in this latest meeting, suggesting that the Fed is still on course to hike again in December, followed by three hikes next year. And we concur there are plenty of reasons for the Fed to continue hiking for now. Growth is above the 1.9% trend, finding staff has turned into the single biggest problem facing corporate America, and our bottom-up analysis suggests core inflation is likely to edge up modestly, to 2¼% by mid-2019. In addition, US financial conditions have not tightened much since the Fed started hiking rates (see chart), which will entice the FOMC to opt for further hikes. We expect continued hikes between now and March next year, bringing the Fed funds rate to 2.50-2.75%.
However, we are less convinced the Fed will deliver all three hikes that are in the dot plot for 2019. Moving from monetary stimulus to neutral conditions is a relatively easy decision, but going into restrictive territory will be more challenging. The US is engaged in a trade war with China and we expect it to be a long one. In this environment there is limited room for the Fed to move into restrictive territory without provoking political push back. In addition, paying high interest rates to banks holding excess reserves is not helping make the Fed more popular in Congress; the bill for this already stands at USD 35 billion per year.
Any suggestions of being influenced by political pressure were denied by Powell during the press conference, but obviously the Fed is not operating in isolation. If at some point it has to make a decision between continuing the balance sheet rundown and hiking rates, this will probably be an easy choice. Furthermore, current Fed policy is starting to create a scarcity of dollars outside the US. So far this has mainly hurt emerging markets, but there is a fair chance that any further EM risk off could hurt broader risk sentiment. If this also leads to wider US credit spreads, a pause in the Fed’s hiking cycle could be the next step.
The market has priced in another 25 basis point rate hike in December and two more next year. We think it will be difficult to price in more than this. As external pressures build, the Fed might end up pausing while labor market conditions are still tight. This outlook suggests there is room for long-term US rates to move higher, reflecting lingering inflation expectations. In addition, the term premium in long-term rates looks set to rise, as global central banks have stopped expanding their balance sheets and the supply of US Treasuries is increasing. The Robeco Global Macro team has recently opened curve steepening positions to express this more bearish view on longer bonds relative to the short end of the curve.