Fed Hikes Rates: Redline, Dots, Projections, Analysis

Ok, here comes Janet.

Wednesday’s setup was made a bit more interesting by the core CPI miss this morning and by the surprise result of the Alabama special election on Tuesday evening (those two things conspired to put pressure on the dollar which was riding its best win streak of the year going into today). Also, the market just learned there’s a preliminary deal on taxes.

As a reminder, a December hike was baked into the cake (it was ~90% priced in as is always the case in a world where the Fed cannot move without the market’s permission). Here’s the recent history of market pricing going into hikes:

The question(s) then, are how Yellen will describe the outlook in what amounts to her farewell address to the market, whether and to what extent tax reform will be factored into the SEP, what specifically is said about inflation and/or the relentless flattening of the curve and finally, whether there’s any mention of stretched valuations in asset prices (more on all of this below).

Bullet points

• FED RAISES TARGET FUNDS RATE RANGE QTR POINT TO 1.25% TO 1.5%
• FED: MONTHLY B/SHEET RUNOFF TO RISE TO $20B IN JAN. AS PLANNED
• FED SEES FASTER 2018 GROWTH, LABOR MARKET STAYING `STRONG’
• FED SAYS EVANS, KASHKARI DISSENT IN FAVOR OF NO RATE CHANGE
• FED RAISES RATES BY QUARTER POINT, STILL SEES THREE 2018 HIKES

Redline

 

Dots

September:

December:

Projections

September:

December:

Below is everything you should need to parse it all.

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This will be Janet Yellen’s last presser as Fed Chair, so whatever you need to do to prepare yourself mentally for that, do it. Here’s what BofAML thinks you should look for as you parse everything:

1. Future path of the hiking cycle: We think Yellen will reiterate the need to proceed with a gradual hiking cycle, even in the face of rising inflation. She will reiterate that most models are still pointing to a low R*, which means a need to be cautious with the speed of rate hikes.
2. Tax reform: We think Yellen will likely be inclined to offer a bit more information about the impact of tax cuts than Powell was in his recent testimony, referencing historical episodes and the literature. She will note that tax cuts should generate a short-term boost to the economy, but will highlight concerns over the crowding out of private investment from deficit expansion. Yellen will also likely caution about adding to the debt given the official CBO estimates of an upward trend, all else equal.
3. Flattening of the yield curve: Yellen will likely be asked about how the Fed thinks about the flattening of the yield curve. She should reiterate that the Fed is not just concerned about the shape of the yield curve, but also the level. Moreover, they are looking at a wide range of financial market indicators and others point to further easing of financial conditions. That said, the yield curve is something that the Fed should keep an eye on to make sure credibility is maintained.

As far as the projections, there’s probably some scope for the tax cuts to be factored in as the Fed has generally joined market participants in fading the fiscal stimulus push throughout the year. As Goldman noted over the weekend, the Fed normally incorporates these considerations in real time. To wit:

It is hard to know to what degree the Fed staff and FOMC participants will adjust their projections at this meeting to account for the impact of the tax cuts, but history offers some guidance. In an earlier analysis of the Fed’s response to major changes in fiscal policy, we found that Fed staff updated their fiscal projections in real time, often before bills were even introduced, and had fully accounted for the impact of past changes by the time they became law, as shown in Exhibit 5. FOMC participants updated their own fiscal expectations nearly as quickly, but began to cite fiscal policy changes in the context of appropriate monetary policy a bit later, closer to when the bills became law. This points to at least some accounting for the tax cuts at the December meeting, at least in the economic projections.

Here’s BofAML’s take on that:

The final FOMC meeting of the year will give us a sense of how FOMC officials see the economy evolving as we head into 2018. A key question is whether FOMC officials include the potential impact of tax reform. Moreover, Randy Quarles will be submitting his forecasts for this meeting, replacing Stanley Fischer’s submissions. In our view, the forecasts are likely to be quite similar, but there is a risk Quarles has a more positive outlook for the longer term, buying into the argument fiscal stimulus and de-regulation could boost longer-term growth prospects.

Yes, “fiscal stimulus and de-regulation could boost longer-term growth prospects.” And as a reminder, they could also pole vault us into a high leverage, high vol. regime if they end up accidentally coinciding with a sudden upturn in inflation.

Anyway, for their part, Barclays expected “a slight upward revision for the 2018 growth path” but notes that “the upside risks to growth and inflation from the tax cuts bill … will be incorporated in the official projections only after the final version has been signed by the president.”

Three interrelated things to keep in mind as you think about the December hike and the SEP:

1. the unresponsiveness of financial conditions

2. the curve

3. the shrinking playground

“Say goodbye”…