FOMC look-ahead

The US Federal reserve is expected to raise rates by 25 basis points this evening, pushing fed funds into a target range of 1.75-2.00%. This would take the headline US interest rate to its highest level since September 2008, at the height of the Great Financial Crisis.

But the rate hike is of secondary importance to what the Fed communicates to the markets. As this is a quarterly meeting there’s also an update to the FOMC’s Summary of Economic Conditions. This is where the Committee presents its forecasts for GDP growth, unemployment, inflation and the fed funds rate for the next two years and beyond.

Given the strength of recent US data releases, particularly the latest Manufacturing and Non-Manufacturing PMIs, it seems most unlikely that the Fed will present a downbeat view of the US economy. But it will have to be very careful not to appear too bullish or investors will start to worry about the central bank’s monetary policy becoming too restrictive.

The FOMC could say the ‘full employment’ part of the Fed’s dual mandate has been met with the Unemployment Rate at an 18-year low of 3.8%. However, this brings its own problems as wage growth has failed to pick up despite a tight labour market. It’s likely that the Fed will have some comments to make on this issue.

When it comes to inflation, it depends which number you choose to consider. Core PCE (the Fed’s preferred inflation measure) stands at +1.8% annualised, just below the FOMC’s 2% target. But yesterday headline CPI came in at 2.8%, its highest level in over six years while the ‘Core’ reading (which excludes volatile items such as food and energy) rose to 2.2%. Now the Fed has made it abundantly clear that it is prepared to see inflation overshoot its 2% target – perhaps for some time. But markets could get spooked if the FOMC sees inflation accelerating from here.

If the FOMC upgrades its overall economic outlook then we may see another upward shift in the ‘dot plot’ of individual members’ expectations for future rate hikes.

On one hand, any increased hawkishness could prove bullish for equities as companies should profit from economic strength. But the flipside is that tighter monetary conditions will make it much harder for corporates to improve on their current performance. After all, we’ve just had an exceptionally strong set of first quarter earnings which means that it’s going to get harder for companies to outperform going forward. This fact won’t be lost on investors.

In addition, any upward shift in interest rate expectations should lift the dollar and US Treasury yields as bond prices sell off. This could be a concern if it leads to a further flattening of the yield curve, particularly if the Fed emphasises that it expects inflation to continue to rise.

Some analysts are speculating that the Fed may calm fears about tighter monetary policy by indicating that it is prepared to reduce its balance sheet from $4.5 trillion to $3.5 trillion, rather than to $2.5 trillion generally expected. Since October last year the Fed has reduced its holdings of Treasury debt and mortgage-backed securities by $102 billion – barely a dent. But this has been enough to raise concerns of a global shortage of dollars down the line which is one of the reasons for the recent plunge in emerging market debt.

There are plenty of moving parts to consider, and that’s before we get to Fed Chairman Jerome Powell’s press conference. Traders should prepare themselves for a sharp spike in market volatility.