The most powerful person in the western world spoke last week. No, not Donald Trump but Janet Yellen. The head of the US central bank testified before two Congressional committees, setting the scene for US interest rate rises in 2017. So what did we learn?
What She Said. Ms Yellen’s formal remarks were brief by past standards and stuck faithfully to the script of the 1st February FOMC statement. However, a couple of phrases did catch the eye.
The first was “waiting too long to remove accommodation would be unwise”. This was quite hawkish by Janet Yellen’s normally dovish standards and the headline writers wrote it up that way. However, in central bank land, “waiting too long” can mean months and quarters. This is simply consistent with the Fed’s declared belief that there will be three rate hikes this year.
And the second was “changes in fiscal policy or other economic policies could potentially affect the economic outlook”. This is a candid reference to the new Trump administration’s likely policies. These include tax cuts (including corporate tax reform) and extra government spending as well as protectionist trade measures. All of these are reasons why the Fed might raise rates faster but none are guaranteed to occur. The FOMC will wait and see.
What The Fed Will Do. The starting point is the Fed’s projections last December. The FOMC’s collective wisdom was that by the fourth quarter of 2017 the unemployment rate would be 4.5%, headline inflation 1.9%, core inflation 1.8% and the Fed funds target range 1.25%-1.5%. In other words, lower unemployment, higher inflation and three rate hikes.
The Federal Reserve is close to hitting its dual mandate of maximum employment and price stability but is not quite there. In particular, the under-employment rate was 9.4% versus its low of 8% in the previous cycle. Thus, the Fed may try to squeeze some more slack out of the labour market before raising rates in earnest.
So, the crucial question is not whether the Fed will raise rates but when and by how much. The futures markets currently assign rate hike probabilities of 34% in March, 60% in May and 75% in June.
That may be overstating things, having been spooked by the words “fairly soon” in the latest FOMC minutes. We would not rule out a March or May rate increase but think it is more likely in June when there will be fresh forecasts and a press conference.
Significantly, Ms Yellen did not flag a March rate rise last week. Investors should mark her every word on 15th March for signals of a May increase.
Investment Conclusion. Our base case is 25bp interest rate rises in June and December and a fair chance of another in September. If this proves correct, then expect moderately higher Treasury yields and maybe a slightly flatter curve. A tighter Fed policy may unsettle US equities … but not fatally.
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