Will the Fed increase interest rates? When? How many times in 2017? What will happen with the USD and the stock market in 2017? What are FOMC members likely thinking now and what is likely to happen to Fed policy going forward? Read this post to get the insights.
All central banks of industrialized countries have a similar approach to policymaking, even if the details vary. In the USA, members of the FOMC vote on the Fed Funds Rate and the FOMC also debates over communications to the public because these communications influence expectations about the future path of the Fed Funds Rate. These expectations then have an impact on current bond yields and long term interest rates such as mortgage rates, corporate debt rates, stock market returns, consumer credit, and more. Will the Fed Funds Rate increase by 1 percentage point over the next 12 months? Less? More? How fast? How will this influence production, jobs, inflation, stocks, the usd, gold, and oil over the 1-3 year horizon? These are typical questions that central bankers try to answer, as well as stock and bond investors and traders.
In the end, the central bank acts as the "pilot of the car" and tries to have the "car" running as fast as possible, but not too fast because that would pose a danger of "overheating" and getting out of control. The central bank "drives the car" with essentially 3 tools: 1) the key interest rates it controls, 2) the balance sheet, 3) communications.
When it increases interest rates, all credit becomes tighter and this tends to "put the brakes" on the economy. When it decreases rates, this tends to "hit the gas peddle" on the economy and increase economic activity and jobs. When the economy is growing and booming, inflation increases and the central bank "puts on the brakes" to avoid overheating, while when the economy is sluggish or contracting, the central bank "hits the gas peddle" with lower rates. The central bank also influences markets and the economy by buying assets (it prints money and buys assets in markets), which adds money to markets and increases asset prices while also increasing credit availability - this is central bank balance sheet expansion, and most central banks have been doing this quite a bit since 2008 to counter massive deflationary forces.
The central bank also influences interest rates, asset prices, and the value of the currency just by what it communicates to the public and the "tone" it uses. A dovish tone tends to depreciate the currency and keeps interest rates low (and stock and bond prices high) while a hawkish tone appreciates the currency and tends to increase interest rates (and creates downward pressure on stock and bond prices). A central bank will adopt a more hawkish tone if inflation is rising above what it considers "acceptable", which is roughly 2%. There are many measures of inflation, but the Fed keeps a close on on core PCE inflation, which is now running at 1.7%, below the 1.8% hit in July 2016 and below the 2.1% of March 2012.
The central bank looks at a lot of data to decide on the path of policy. The danger of keeping rates too low for too long is that the economy starts to overheat and can build bubbles in real estate, stocks, bonds, etc., along with rapidly rising inflation and inflation expectations that create a need for a fast and potentially destabilizing pace of rate hikes. The danger of starting to increase rates when it isn't time is to create a slowdown that is not needed and a potentially abrupt selloff of stocks and bonds that start a negative feedback loop into market mood and consumer behaviour.
The typical data the central bank looks at is:
Currently (Feb 11, 2017), the Fed is in a very touchy spot. The economy appears to be running close to full "potential" on some measures (although I personally think there is plenty of remaining slack) and Trump has boosted mood about the economy, with a clear improvement in business confidence. Jobless claims are low and things seem to be generally improving. Yet, I am looking at ALL the possible indicators on FRED and on TradingEconomics.com and I do NOT see any need to hurry on rate hikes.
Price pressures are NOT convincing, labor market conditions are still slack (as indicated by the close-to-zero-but-improving labor market index), the USD is very strong (which weighs on exports) and appreciated tremendously in 2016H2, which creates downward pressure on inflation into 2017. The Fed probably sees this as well, but may want to start communicating that rates might indeed increase at a "modest pace." In other words, the Fed will want to signal the continuing of the tightening bias, but not with a very hawkish tone.
That said, the case for a bit more hawkishness is "a bit stronger" than before, with increasing inflation and business mood, potential fiscal expansion by Trump, good job creation (but nothing stellar), and increasing inflation expectations (but still on the low side historically). I simply do not see any hurry because most indicators are still weak and on the "low" side, even if they show clear improvements.
The Fed is likely to keep the same message, with a moderate increase in the Fed Funds Rate of 2 more hikes in 2017 (which is already priced in by the market in stocks, bonds, and exchange rates), although the tone may prove tricky to find, as the Fed wants to signal that it is "on top of things and not behind the curve" but not in a hurry either, so that it does not create a negative impact on asset prices, financial conditions or too much currency appreciation.
It is extremely tricky at this point. The communication strategy will be quite a challenge regardless of the message the Fed wants to send, whether it wants to seem "a bit more hawkish" or "prudently neutral." Each data point will be crucial going forward and the path of rates could end up being more hawkish than expected (usd bullish) or more dovish (usd bearish). We really have to follow things especially closely right now. The Fed may lean towards a "prudently more hawkish" stance going forward, as the case for the already-priced-in rate hikes has at least become more convincing. Stay tuned into the market to remain ahead of the curve and be sure to read my posts, as I will keep you on top with regular updates. Like and share!