Fed preview: The second rate hike is coming - Commerzbank

The Fed will most probably increase the Fed funds target range by 25 basis points at its meeting next week, according to Bernd Weidensteiner, analyst at Commerzbank. The financial markets should quickly tick this off and turn to the medium-term outlook.  Fiscal policy will play a major role in determining the scale and pace of further rate moves the analyst noted and added that the economic policy of the future Trump administration carries much uncertainty but increasing scope for rate hikes is gradually emerging.

Key Quotes

“Even the doves in the FOMC now believe the Fed is about to reach its targets. Unemployment fell to 4.6% in November, which is below the current FOMC estimate of the “natural” unemployment rate of 4.8%. Furthermore, high labour market utilisation is ensuring a gradual rise in price pressure so that the inflation target should also be achieved in the foreseeable future. It is therefore appropriate to make monetary policy “somewhat less accommodative” to quote the words of New York Fed president William Dudley in a recent speech.”

“One year after the first rate step, the Fed thus looks set to decide on the second move at its meeting on 13/14 December. The target corridor for Fed funds would thereby increase to 0.50%- 0.75%. The Fed is also likely to decide to replace maturing bonds in its portfolio by new bonds for the time being. According to current Fed rhetoric, the central bank would not allow its balance sheet to shrink until a later point in time in the normalisation process. The reinvestment policy debate should gain momentum in the course of next year.”

“But what will happen then? This will largely depend on the fiscal policy stance of the incomingnUS administration. Before Trump’s election victory, senior Fed representatives had in various speeches voiced a need for fiscal policy to play a greater role in strengthening US growth. Trump’s aggressive tax cut plans and the emerging acceleration of the US economy have in any case evidently led to a rethink. There are now apparent risks for public finances and the preference is for less financial stimulus in order to keep the powder dry for a possible crisis in the future.”

“A significant acceleration of fiscal policy would in any case increase inflation pressure. This could then lead to faster interest rate hikes than originally anticipated by market participants who have already adjusted their expectations. While only a few weeks ago, they could only imagine a single further move on rates by the Fed, they are now not very far away from the current “dots” (the opinion of senior Fed members on the likely interest rate path based on current projections); besides the hike next week, the dots show two further steps for 2017.”

“Against this backdrop, the FOMC’s updated projections will draw much attention next week. So far, the dots have constantly fallen over time; the FOMC has steadily reduced its rate hike expectations. It seems premature for a change though, as the new government’s plans are not quite clear yet. The Fed will therefore want to wait and see where  the journey is heading. For now, we stick to our forecast of two interest rate rises next year.”