FOMC Preview: Three is a mirage - Rabobank

Philip Marey, Senior US Strategist at Rabobank continues to think that the third hike in the Fed’s plans for this year will not materialize, as inflation is moving away from the 2% target, which could also delay the Fed’s plan for balance sheet normalization.

Key Quotes

“The FOMC will meet on July 25 and 26 and conclude with a formal statement; there will be no press conference. A change to the target range for the federal funds rate is highly unlikely, only one month after it was raised to 1.00-1.25%. The June hike was the second this year, after the Fed started in March. While the Fed continues to aim for three rate hikes this year, inflation is moving away from target.”

“In May the PCE deflator, the Fed’s preferred measure of inflation, caught up with the decline in the core: both fell to 1.4%. Back in February headline inflation was 2.1% and core inflation 1.8%. This shows that we are currently moving away from the Fed’s 2.0% target for PCE inflation. Since core inflation is slowed down by a persistent decline in education and health care inflation, this move is likely to be sustained.”

“For now, the FOMC may continue to indicate that it intends to stick to its plan to hike three times this year, but if inflation continues to undershoot the Fed’s target and expectations, the doves are likely to gain ground in the Committee. Note that Kashkari (Minneapolis Fed) voted against the decision to hike in June because inflation is not coming up to the Fed’s target. Several other FOMC participants have also expressed their doubts about the inflation outlook and have indicated that continued weak inflation readings could make them reconsider their rate outlook. They are finding support in the financial markets that have reduced their expectations of what the Trump administration can deliver in terms of tax cuts and infrastructure spending and consequently their expectations of inflation. This has led to a decline in longer-term US treasury yields since March.’

“The slow progress of Trump’s policy agenda and the inflation data support our long held view that the market euphoria after Election Day was overdone and that the Fed succumbed to the animal spirits when they started hiking early in the year. The markets are now increasingly subscribing to our view. We continue to think that the Fed got ahead of itself earlier in the year and that they will come to realize that hiking twice is more than enough for 2017.”

“In addition to clues about the Fed’s take on inflation and its implications for the next rate hike, the markets will be focused on clues about the Fed’s balance sheet. In fact, the FOMC expects to begin implementing its balance sheet normalization program ‘relatively soon’, provided the economy evolves broadly as anticipated. Several participants prefer to announce a start to the process within a couple of months. However, some others emphasize that deferring the decision until later in the year would permit additional time to assess the outlook for economic activity and inflation.”

“A few of these participants also suggest that a near-term change to reinvestment policy could be misinterpreted as signifying that the Committee has shifted toward a less gradual approach to overall policy normalization. The market consensus expectation is that the Fed will make an announcement at the September meeting. However, if the Fed’s outlook for economic growth and inflation becomes less optimistic – and more realistic – in the coming months, then we could see a delay in both the next hike and the balance sheet normalization program.”