What a difference a year makes. Last year, skeptics feared that the U.S. economy might struggle to cope with even a single rate hike. This time around, the bigger fear in the market is that the Federal Reserve (Fed) might be falling behind the curve.
The Fed has certainly taken its time, raising interest rates to 0.5-0.75% only at the end of the year. As in December 2015, the decision was unanimous. The widely expected move reflects a broader reassessment by capital markets in recent weeks, after Donald Trump’s victory. U.S. equities have reached record highs and 10-year U.S. Treasury yields have gained more than 60 basis points since the election; they are now above 2.5%. Both inflation and growth expectations have risen swiftly.
In the press conference, Fed president Janet Yellen suggested that the economy may already be back in the vicinity of full employment. This would hint at sharply higher rates, if and when we see a sizeable fiscal stimulus from the new administration. Unlike markets, however, the Fed looks set to wait until the fiscal policies of President-elect Trump become clearer, before reassessing its growth forecasts.
To be sure, the dots plot, which charts the target rates of Federal Open Market Committee (FOMC) participants going forward, suggests three rate increases in 2017, rather than two. The median forecast for the federal funds rate moved up to 1.4% for 2017, from 1.1% in September. This is noteworthy, if only because revisions to the dots in recent years have only known one direction: downwards. Similarly, it has been a long time since the Fed has revised its projections for gross-domestic-product (GDP) growth upwards, even if only slightly.
However, we would caution against reading too much into this or indeed the initial market reaction. Some dots (i.e. those of the Fed leadership) carry more weight than others, and in any case, the distribution was skewed to the upside last time around while it is skewed to the downside now. In other words, the median FOMC participant has gone only from expecting slightly more than two hikes to slightly less than three hikes. Depending on incoming data, this change may not prove all that dramatic.
An additional complication is that it remains unclear what monetary policy the Trump administration might push for. This is a major concern, given that there are two vacancies on the FOMC already and that at least two more, namely the chair and the vice-chair may need to be filled by the summer of 2018.
During the press conference in December 2015 that accompanied the initial rate increase, Yellen said “I think it is a myth that expansions die of old age.” In the light of the recent rebound in growth expectations, that assessment looks as valid as ever. In order to keep the expansion going, however, it would certainly be helpful for the new administration to provide more clarity on both fiscal policy and its plans on how to fill FOMC vacancies. In the meantime, we stick to our strategic forecasts, including a strengthening U.S. dollar, but caution there could be some profit taking in coming weeks.