FX: Fed indicates steeper path for US rate rises in 2017
The painstakingly gradual loosening of US monetary policy continued this week, with the second rate rise in the cycle coming one year after the first, but the Fed gave markets something to think about by indicating it expects to raise rates three times in 2017.
Some had speculated the Federal Open Market Committee (FOMC) might surprise the markets with an aggressive 50 basis point rise. Few predicted they would be left on hold again.
In the end, the Fed’s decision to hikes rates by 25bp, only the second raise of the cycle – and of the past 10 years – surprised nobody, though it did push USD to a 14-year high.
The more debatable subject has long been the future path for tightening, and here there was more of a surprise, the Fed indicating its intention to raise rates three times in 2017 – instead of the two as previously suggested.
Sceptics will point out that 2016 was supposed to deliver multiple rises, and markets had expected the Fed funds rate to be in a 0.75% to 1% range by now, rather than the 0.50% to 0.75% actual range. So there is still plenty of scope for events to get in the way of the Fed’s plans.
However, Steven Englander, global head of G10 FX strategy at Citi, says Fed chair Janet Yellen’s talking up of the US economy suggested there could be even more than three hikes next year.
“Maybe they wanted to move the path even more, and were deterred by the fear that the market reaction would be even worse,” he says.
Neil Williams, Hermes
More hikes in 2017 might not only be the result of positive economic news, says Neil Williams, group chief economist at Hermes Investment Management.
“The emergence of the ‘wrong sort’ of inflation – cost-push caused by goods and labour shortages, rather than demand-pull – would make any knee-jerk Fed tightening, if at all, short lived as the US economy stagflates,” he says.
The mood of uncertainty is likely to prevail until there is more clarity over US president-elect Donald Trump’s plans for fiscal policy. It is anyone’s guess whether that will be the case by the time of the FOMC’s March meeting.
The FOMC acknowledged this uncertainty by declining to make notable changes to its economic projections. Ignoring the recent rally in equity markets and sharp increases in Treasury yields, inflation expectations and the US dollar, it preferred to wait to assess the impact of new policies before making new projections.
While lower taxes, less regulation and higher spending on infrastructure and defence are expected to be supportive for the economy, these benefits might be offset to some extent by a protectionist stance in trade, so it makes sense to wait to see what relative weighting these contrasting policy drives are given.
And if the net result will be positive for growth, it remains unclear when the result will kick in.
Ken Taubes, head of investment management for the US at Pioneer Investments, says the benefits of Trump’s policies might not be fully realised until 2018.
“Trump has already indicated that his top priorities in his first 100 days – the Supreme Court, Obamacare and immigration – are not related to economic growth,” he notes. In addition, income tax cuts may be phased in gradually, and for the wealthy they may be offset by reductions to deductions.
David Absolon, investment director at Heartwood Investment Management, says the Fed’s move was no game changer.
“The difference to last December is that this time inflation has a positive impulse. The market reaction in the next few days is not irrelevant, but it will be in January to see whether the market has over-tightened financial conditions.”
Inflation has been given a recent boost by the rebound in the oil price, though Capital Economics believes the average inflation rate in the G7 was set to rebound to more than 2% early next year even before oil’s rally.
Capital Economics says: “In the US, Trump’s planned fiscal stimulus should boost US demand at a time when the economy is already near full capacity. But we do not think this will mark the beginning of a sustained increase in inflation throughout the world.
“There is still a lot of spare capacity in many advanced economies and little prospect of significant fiscal stimulus outside the US. Moreover, inflation expectations generally remain low.”
In emerging markets, sluggish growth will keep a lid on inflationary pressures, says Capital Economics. While US fiscal policy should provide some stimulus for global demand in 2017, this is likely to be offset in Europe by concerns over the deteriorating political situation.
Attention now turns to the UK, where the Bank of England (BoE) decided on Thursday to leave the rates unchanged.
Derek Halpenny, Bank
Derek Halpenny, European head of global markets research at Bank of Tokyo-Mitsubishi UFJ, says: “The pronounced fears amongst market participants over pound-induced inflation in the immediate aftermath of Brexit have receded notably.”
UK inflation expectations do remain elevated, but this is largely the result of energy prices.
“Energy inflation is starting to tick up and there’s plenty more to come,” says Halpenny.
Energy’s contribution to CPI jumped on an annual basis from 1.7% to 3.0%, adding close to 0.1% of the increase in the overall annual increase from 0.9% to 1.2%, he notes. However, future moves will be even more brutal, to as much as 0.8% on an annualized basis, Halpenny predicts.
The core CPI rate also moved higher, from 1.2% to 1.4%, but stripping out energy reduced the increase from 0.9% to 1.0%.
Halpenny says: “Outside of energy, we have to conclude that the upward pressure on inflation remains very muted.”
Barclays revised its 2017 CPI forecast up 0.1% to 2.5%, incorporating upside news on food and energy prices, with its core CPI forecast for 2017 remaining unchanged at 2.2%.
Paresh Davdra, CEO and co-founder of RationalFX, says: “Higher inflation strengthens the case for raising interest rates. However, a bullish pound based on notional hopes of tighter BoE policy is merely speculative as the policymakers are expected to keep interest rates at record lows.
“The currency outlook for 2017 now seems duller, especially if the political debate on Article 50 intensifies.”