Global Daily – Fed sticks to Fed rate hike view

by: Bill Diviney , Aline Schuiling , Kim Liu , Georgette Boele

In this publication: Fed view – Dissent points to scepticism on inflation. Global Markets: US Treasury yields and US dollar lower. US Macro: Core inflation remains benign. Euro Politics: Italy set for elections in March

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Fed view – Dissent points to scepticism on inflation

The FOMC hiked a further 25bp at its December policy meeting, taking the target range for the federal funds rate to 1.25-1.50%. While most voting members of the FOMC supported the hike, long time dissenter Neel Kashkari was joined by Charles Evans in voting against the action. While neither FOMC members have voting rights next year, the increase in dissent could suggest that concern about weak core inflation is strengthening – a concern that would not have been helped by today’s reading (see below).

The most notable change in the accompanying statement was that the FOMC now expects the labour market to ‘remain strong’, rather ‘strengthen somewhat further’ as in the November statement. In her final press conference as Fed Chair, Janet Yellen specifically referenced this change, explaining that the committee expects the reduction in policy accommodation to reduce the pace of job gains over time, and reiterating that allowing the labour market to overheat would raise the risk that policy needed to tighten ‘abruptly’ at a later stage. This could be interpreted that the Fed would be minded to tighten more than it is currently projecting if job gains failed to moderate in line with its expectations.

The quarterly update to the Summary of Economic Projections showed an upgrade to the 2018 growth forecast to 2.5% from 2.1%, with unemployment now expected to fall to 3.9% from 4.1% previously. When asked at the press conference about the stimulatory prospects of tax reform, Chair Yellen cautioned that some FOMC participants had already factored the potential for fiscal stimulus into their growth projections, and therefore that the forecast upgrade should not be seen as an estimate of the growth impact from the Republican Party’s tax proposals. Yellen also sought to downplay expectations that the Fed might accelerate the pace of rate hikes to offset the stimulatory impact of the proposals, pointing to the potential for supply-side improvements that could offset the direct stimulus to aggregate demand – which would blunt any inflationary impact.

While there was some expectation in the market that the FOMC might project four rate hikes next year, the median in the December SEP continued to point to three hikes, though the median projected rate for 2020 rose modestly to 3.1% from 2.9% previously. We continue to expect subdued inflation to lead to a slower pace of Fed rate hikes than is currently projected by the Fed, with two further rate hikes pencilled in for 2018. (Bill Diviney)

Global Markets: US Treasury yields and US dollar lower

There was market relief after the FOMC’s unchanged guidance that it would raise interest rates three more times in 2018. In the run-up to the meeting, some analysts and investors speculated that the Committee would signal four hikes. As a result, US Treasury yields declined by around 5 basis points across the curve. The US dollar also moved lower. EUR/USD rose from 1.1760 to above 1.1820, while USD/JPY dropped from 113.00 to 112.55. Gold prices profited from US dollar weakness. Gold prices rose by USD 10 to above USD 1,255 per ounce. Tomorrow the focus will be on the ECB.  The ECB in our view will remain dovish, which could trigger the closing of speculative net long euro positions after the meeting, leading to euro weakness. (Georgette Boele)

US Macro: Core inflation remains benign

Core CPI inflation rose by 0.1% mom in November, which was in line with our forecast but below consensus expectations (0.2%). The annual rate fell to 1.7% yoy from 1.8% in October. Shelter inflation continued to be the main source of upward pressure, rising a further 0.3% mom, but this was offset by the biggest mom fall in apparel since September 1998, alongside a decline in airfares. The softness comes in contrast to the relatively strong reading in core PPI yesterday, but is consistent with our view that inflation will remain benign over the coming year. We believe upward pressure on inflation from cyclical forces, particularly the tightening labour market and a pickup in wage growth, will strengthen in 2018. But we expect this to be offset by a continued structural drag from technological change and the recent recovery in productivity growth, which is bearing down on unit labour costs. (Bill Diviney)

Euro Politics: Italy set for elections in March

Various newspapers have reported today that Italy will most likely hold General Elections on 4 March of next year. The exact timing is still uncertain as it depends on the final passage of the 2018 budget law. The general election was already highly anticipated and follows the parliamentary approval of the new electoral law (Rosatellum) in October. The General Elections are seen as the next test for the EU project following elections with relatively benign (if mostly fragmented) outcomes in the UK, Austria, the Netherlands, France and Germany. The Italian elections will be scrutinized as the anti-establishment Five Star Movement has taken a slight lead over the Democratic Party (PD) in recent polls. In the past, the Five Star Movement party was in favour of Italy leaving the EU, but it does not pursue this objective anymore. Nonetheless, the political landscape in Italy is fragmented and recent polls indicate that none of the possible political alliances will achieve a majority of votes. In addition, the new electorate law will not be decisive as there will be no winner bonus. Therefore, it is very unlikely that a stable coalition government can be formed after the elections. This implies that economic reform and improvement of Italy’s government finances will be very difficult. Italy scores poorly on global and European competitiveness rankings and its relative position versus Spain, Portugal and Greece has deteriorated in recent years. Moreover, Italy’s government finances will deteriorate rapidly in case of a sudden rise in interest rates or decline in economic growth or both. In reaction to the newspaper reports, 10y Italian sovereign bonds underperformed compared to German as well as other peripheral bond markets. The initial widening compared to 10y Bunds was modest at only 4 basis points, but increased as the day progressed to almost 10bps. The underperformance of Italian bonds also dragged Spanish and Portuguese bonds down. The Italian bond underperformance is signaling investor anxiety about the uncertain outcome of the General Elections. Indeed, we expect the 10-y Italian – German spread to increase further in the run up to the elections and to tighten once a government eventually is in sight, albeit at a modest pace. (Aline Schuiling & Kim Liu)