Fed: Which direction it will go in next year? – Danske Bank

The Fed’s blackout period ahead of the FOMC meeting on 20 September has begun and three of the voting FOMC members (Brainard, Kashkari and Kaplan) took the opportunity last week to express concerns about inflation, as it continues to run below the 2% target, notes the analysis team at Danske Bank.

Key Quotes

“While the Fed will most likely announce “quantitative tightening” at the upcoming meeting, the dovish speeches support our view that it is not a given the Fed will hike again in December although it remains our base case. The problem for the Fed is that it has two goals – maximum employment and 2% inflation – but only one instrument (the fed funds target range). The reason we still believe the Fed will hike in December is that the core FOMC members put more weight on the labour market data, not least due to Yellen’s strong belief in the Phillips curve. NY Fed president Dudley supported this view in his recent speech.”

“We think the probability of a December hike is 55%, so we seem in between market pricing (20%) and the consensus among analysts. We still think risk is skewed towards the Fed pausing its hiking cycle, as it is likely still too optimistic on inflation due to the low inflation expectations. We still see a case for slightly higher US yields in Q4 as the markets reprice the probability of a December hike although the US debt limit risk returns in Q4.”

“Still, the biggest unknown with respect to the Fed is what happens next year, not least following the announcement that Vice Chair Stanley Fischer has resigned with effect on or around 13 October due to personal reasons. Fischer’s resignation leaves four vacant seats out of seven on the Fed Board of Governors. The governors are nominated by Trump but the nominees are subject to Senate approval. The number of vacancies may increase to five if Trump does not reappoint Yellen, which we do not expect, although the probability has increased after the Wall Street Journal reported that Trump is unlikely to nominate Gary Cohn as next Fed chair given Cohn’s comments in reaction to Trump’s statements after the Charlottesville riot. As Trump does not seem interested in monetary policy (he seems to think of economic policy in terms of trade policy and tax reform/deregulation/infrastructure investments), we think his Republican advisors will advise him to nominate traditional Republican candidates, which would likely lead to a more hawkish and rule-based Fed.”

“A simple Taylor rule, which links the fed funds rate to inflation and unemployment, suggests the rate should be around 3% now (although we think this rule overestimates the appropriate level of the fed funds rate, as structural factors have lowered the so-called neutral rate (the appropriate interest rate level when the output gap is closed and the economy is in equilibrium). Overall, the risk is that the Fed may become less independent and raise rates too much.”