FOMC: The season for a hike - BNPP

Analysts at BNP Paribas suggests that the December FOMC meeting is expected to bring the second rate hike of this cycle and the challenge for the Fed will be reacting to an uncertain fiscal stimulus that could potentially disturb its forecast of growth moving slightly above potential and inflation gliding up to target.

Key Quotes

“Expectations for the policy statement 

• We expect the following changes in the first paragraph: 1) Economic activity to be characterized as “expanding at a moderate pace”, with the reference to H1’s modest pace dropped.  2) Acknowledgement of improved labour market conditions, something like: “A range of recent indicators, including ongoing, solid job gains and declining unemployment, shows further improvement in the labour market". 3) Market-based measures of inflation compensation to have moved up “further” with the phrase “but remain low” dropped.
• With Brexit, the US election and the Italian referendum all in the past, there is no obvious risk event on the near-term horizon. Accordingly, we expect “near-term” and “roughly” to be dropped from the risks assessment; the sentence will likely just read: “Risks to the economic outlook appear balanced.” The Committee could drop its sentence about “closely monitoring” inflation and global economic and financial developments – though this is not our baseline.
• We expect the Federal funds rate target range to be raised 25bp to 0.5-0.75% and the Committee to describe the stance of policy as accommodative “after this increase.” We expect no change to the guidance on reinvestment policy and the decision on rates to be unanimous. Forward guidance about the future pace of rate hikes should be virtually unchanged. There may be increased emphasis on policy being dependent on current and expected economic developments, making it clear that the Fed will react to fiscally induced changes in growth and inflation, even if these are just prospective.”

“Expectations for the Summary of Economic Projections (SEP)

• The fiscal policy outlook has brightened, but remains uncertain; most FOMC participants will probably wait for more clarity before adjusting their forecasts substantially. Overall, we expect few changes in the SEP economic projections, especially for 2017-19.
• The 2016 headline PCE inflation forecast seems too low, and we believe it could be revised up 0.2pp to 1.5% on the back of the OPEC news, which raised spot energy prices. The 2016 core PCE inflation projection could be raised 0.1pp to 1.8%; but, we believe the more likely outcome is that it remains unchanged at 1.7%. Given the downside surprise to November’s unemployment rate, we expect the 2016 unemployment projection to be lowered 0.1pp to 4.7%. Growth for 2016 could be nudged up 0.1pp to 1.9%, but we would not be surprised to see it stay at 1.8%. 
• Given a roughly unchanged economic outlook, we expect no change to the median dot path: 0.625% (2016), 1.125% (2017), 1.875% (2018), 2.625% (2019) and 2.875% (long term).” 

“Expectations for the Chair’s press conference

• Fed Chair Yellen will likely emphasize that policy remains data dependent. Undoubtedly, she will be asked by reporters what recently proposed fiscal policies mean for the economic outlook. Her message will likely be that it is too soon to speculate on the nature of future fiscal policy, but that it may well affect both the growth and inflation outlooks. We would expect her to say that FOMC participants have incorporated their own assumptions about fiscal policy in their individual projections. The main takeaway is that the outlook for the next two years is somewhat uncertain and that policy will ultimately be data dependent.
• Risks The risk is that some FOMC participants might revise up their outlooks, leading to a more hawkish set of interest rate dots or projections of inflation that overshoot the 2% target. Both would have the same result: higher rates. The difference is how we would get to that result (more rate hikes priced in vs higher breakevens and risk premia). We think the Fed will choose to cross this bridge later, and thus, we expect fewer changes in the projections and communication. But, the risks to our forecast are skewed to a more hawkish outcome.”