News in Charts: US interest rates will rise but do not be fooled by the ‘dot plot’

The FOMC raised the fed funds rate for just the second time in ten years last Wednesday, but it was the revisions to the ‘dot plot’ that grabbed the headlines and pushed yields on US Treasuries higher. We think investors are right to expect a faster pace of tightening than we have seen over the last year. But there was little in Janet Yellen’s press conference or the summary of economic projections to suggest that such a move is imminent.

According to the Fed Chair, the revisions to the dots were “really very tiny” and FOMC participants left their outlook for inflation, unemployment and economic growth virtually unchanged as they await more clarity on Donald Trump’s economic plans. But Fed policy is not entirely dependent on Mr Trump’s plans: the labour market is tight, wages are rising and the Phillips curve is not dead! The bigger picture is that while we expect a further six quarter-point increases in the fed funds rate by end-2018, real short-term rates will remain negative for some time.

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Donald Trump’s victory in last month’s US presidential election has prompted investors to recalibrate their expectations for US monetary policy. A significantly quicker pace of tightening is now implied by fed funds futures than on 8 November, as investors bet that Mr Trump’s fiscal stimulus will push US inflation higher. We think investors are right to assume a faster pace of tightening than we have seen in the past year. However, it remains to be seen how much of Mr Trump’s planned stimulus will get approved by Congress and when it will take effect. In our view, the impact of this stimulus is unlikely to be seen before the second half of next year, at a time when the US labour market will be running above its potential.

Higher oil prices and base effects are set to push headline inflation above 2% early next year. However, significant upward pressure on core inflation is more likely to occur in the second half of 2017 and throughout 2018. With the FOMC likely to favour keeping the economy running ‘hot’ than pre-emptively raising rates, we expect just two quarter-point increases in the federal funds rate in 2017, but four in 2018. Significantly, in our view, this trajectory is consistent with a negative real fed funds rate over the forecast horizon.

The FOMC raised rates but what happened next?

The FOMC’s decision to raise the federal funds rate by 25 basis points had been entirely priced into federal funds futures before last Wednesday’s announcement. The subsequent increase in Treasury yields and rise in the probabilities that investors assign to future hikes was apparently due to the revision to the FOMC’s ‘dot plot’. The number of 25 basis point increases in 2017, implied by the median dot rose from two to three last Wednesday, although Janet Yellen downplayed the revisions in her press conference, stressing that they were “really very tiny”.

In fact, the fed funds rate for end-2017 implied by the mean of the FOMC participants’ dots was revised up by just 6 basis points to 1.38%. More significantly, their projections for inflation, unemployment and economic growth in 2017 and 2018 were virtually unchanged compared with September and apparently did not take into account the possible changes to economic policy by the incoming administration. The bottom line is that the dots could be revised higher once Mr Trump’s plans become clear, but it would be a mistake to read too much into last Wednesday’s shift.

All change at the FOMC?

Contrary to some reports, we see little evidence that the FOMC will take a more hawkish bias next year. Janet Yellen confirmed last Wednesday that she intends to see out her term as FOMC Chair until February 2018. And although Mr Trump will be responsible for filling two vacant seats on the FOMC’s Board of Governors in 2017, he has little incentive to fill them with hawks. We very much doubt that Mr Trump wishes to see a sharp tightening in monetary policy, which would increase the costs of his fiscal stimulus and also hinder his efforts to narrow the current account deficit by putting further upward pressure on the dollar.

It is also doubtful whether the annual rotation of FOMC members will result in a more hawkish bias among voting members next year. Three of the four outgoing alternate members voted for a rate increase at the FOMC’s meeting in September. The incoming members, which include Charles Evans of Chicago, a well-known dove, do not appear to be much more hawkish.

Outlook for the labour market

Last year we estimated that the breakeven rate of payroll growth was 60,000 per month, a level that appears to be a lot lower than generally perceived. We also observed that most of the decline in the labour market participation rate in recent years is structural, not cyclical.

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Indeed, with the US economy still adding jobs well in excess of 60,000 per month and the participation rate now close to trend, there appears to be little slack left in the labour market. Admittedly, wage growth is lower now than at the same stage of previous economic cycles, but average hourly earnings hit a post-recession high of 2.8% in October and consumer and business surveys both point to diminishing slack in the labour market. Last but not least, our labour market model suggests that the Phillips Curve is alive and kicking!

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Overall then, we think investors have been right to revise the probabilities they assign to US interest rate increases next year higher. But if the labour market continues to evolve as we expect, we still think that investors are underestimating the pace of tightening in 2018 when the effects of Mr Trump’s stimulus are most likely to feed through to the economy. Although we forecast a combined total of six quarter-point increases in the fed funds rate between now and the end of 2018, this would still be consistent with negative short term rates over the forecast horizon.

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