We expect the FOMC to increase the federal funds target to 0.75-1.00% at the conclusion of their next meeting. Over the past two weeks, many FOMC members, including Chair Yellen, have sent clear signals that they will raise the federal funds target next week, barring any drastic changes to the outlook. Since the January meeting, financial conditions have improved and the risk that the economy is gaining momentum has increased. Therefore, we expect that the distribution of the FOMC participants’ policy rate projections (the “dots”) will likely become less dispersed largely because the lower tail of distribution shifts to the median. However, we expect the median of the participants’ policy rate projections for 2017 and 2018 to remain unchanged, implying three hikes for 2017 and 2018, respectively. We do not expect changes to the FOMC’s long-term forecast for the policy rate. Elsewhere in the SEP, we expect only small changes to their GDP or unemployment rate projections. The median of their forecasts for core PCE inflation for 2017 could be revised up slightly to 1.9% from 1.8% previously, reflecting the recent firming of core goods prices.
Economic Momentum – Gaining or Not?
One main question facing the FOMC is whether the economy is gaining momentum, hastening the need for higher short-term interest rates. We believe that FOMC members have concluded that the risk of the economy gaining momentum has increased, but not necessarily that the economy has picked up. The economic data – on spending, labor markets, and business and consumer sentiment – continue to send mixed signals. Spending in January came in below expectations on net. Tracking models using these data suggest Q1 GDP growth of around 1.5%. For February, the one spending indicator in hand is motor vehicle sales – they remained flat in February after having fallen in January. Retail sales for February will be released on the morning of the 15 March, while the FOMC is meeting. Tax refunds were slower than last year in February, which may have been a drag on consumer spending.
By contrast, employment data for January and February show some pickup in activity. Nonfarm payrolls increased and exceeded expectations in both months, increasing by 238k in January and 235k in February. Private payroll gains averaged 224k in January and February, up from an average pace of 153k in Q4. More important, the growth in aggregate hours worked appears to be picking up. Aggregate hours grew at a 2.2% annual pace over the last three months.
However, the latest employment report does not show a substantial tightening of the labor market. The unemployment rate has oscillated between 4.6 and 4.9% over the past 10 months, consistent with the Fed’s view of full employment. However, labor force participation has edged higher in recent months, reaching 63.0% in February, the highest level in 11 months. Further, the U-6 unemployment rate fell by 0.2pp to 9.2% in February, which is a percentage point above the levels witnessed before the previous recession. Consistent with the story that slack remains in the labor market, average hourly earnings have been growing only modestly in recent months and have not shown signs of notable acceleration.
Very positive consumer and business sentiment, as reported in a wide variety of business and consumer surveys, is probably the most important factor that could drive up economic momentum. The most recent readings of surveys of small businesses, manufacturers, non-manufacturers, and home builders all show higher levels of optimism than late last year.
An ongoing source of uncertainty for the economic outlook and the FOMC is fiscal policy. The anticipation of expansionary fiscal policy since the election has certainly been one of the main drivers of improving financial conditions, optimism in business surveys, and perhaps the payroll data. However, clarity over the size, type, and timing of fiscal policy remains unclear. If anything, the timing on when the uncertainty will lift over fiscal policy has likely been delayed since the previous FOMC meeting. For spending, President Trump won’t submit a budget until May. Only a budget outline proposal is to be released next week, and it may not be until September when a budget for FY 2018 is passed. The extent to which Congress will increase net discretionary spending is very unclear. One hurdle the Republicans face is the procedures and rules that straight-jacket their discretion in spending, and changing these rules may be very difficult.
For tax policy, the low probability that a tax package will be passed before the August recess may have been reduced further. Senate Majority Leader McConnell said that the Senate wouldn’t take up taxes until the fall. Even then, it is unclear what will ultimately pass and how large of a fiscal boost it will provide.
One reason for the increased uncertainty is the challenges the Republicans face in replacing the Affordable Care Act (aka, Obamacare). Despite an enthusiastic push to get a replacement package through the House and Senate, serious opposition to the House proposal is arising from a number of groups, including fiscally conservative Republicans, hospitals, doctor groups, the AARP, and moderate Republican Senators. Replacing Obamacare could prove to take up more time and political capital than originally envisioned, pushing back the time table for the tax reform. On the other hand, either quick passage or quick failure of the current attempt to roll back the ACA could allow the Republicans to move on to tax reform more quickly than expected. We, and the FOMC, will just have to watch and see how these events unfold.
Since the December FOMC, it appears that participants have become less concerned about external risk. This assessment may have increased policymakers’ confidence in their economic outlook. Over the past two years, we experience global financial turmoil fueled by Chinese stock and foreign exchange markets; Brexit; and big swings in the USD and commodity prices. Recent statements by the FOMC participants suggest that they see downside risks to the economic outlook from potential external shocks. On balance, the risk that the economy is gaining momentum has increased. However, the risk that fiscal policy fails to meet expectations, which could jeopardize those gains, has also increased.
Summary of Economic Projections
Reflecting the upside risk to the economic outlook, we expect that the distribution of dots will likely become less dispersed largely because the lower tail of distribution will shift upwards. However, we expect the median of FOMC’s policy rate projections for 2017 and 2018 to remain unchanged implying three hikes for 2017 and for 2018. As for the longer-run projections of the policy rate, which represents estimates of the neutral rate, we think the distribution will essentially remain unchanged.
Elsewhere in the SEP, we expect few changes to the FOMC participants’ projections. However, as discussed above, their risk assessment of their outlook may have improved and more participants could see the balance of risks weighted toward the upside. As announced last week, the FOMC will start providing new charts on the FOMC participants’ perceived degree of uncertainty and balance of risks associated with their economic projections along with the fan charts. Moreover, the median of their forecasts for core PCE inflation for 2017 could be revised up slightly to 1.9% from 1.8% previously, reflecting the recent firming of core goods prices. Note that they removed the language on transitory factors holding down inflation from the post-FOMC statement in the previous meeting.
The upcoming meeting will be followed by Chair Yellen’s press conference. It seems clear that the FOMC reached a strong consensus on the near-term trajectory for policy ahead of their last round of public comments. Not much has changed since they made those comments. In that context, we do not expect Chair Yellen to send a message that is notably different from what she gave us in her speech in Chicago. That said, she may note how external factors affecting the US outlook, including geopolitical risks, exchange rates, and global financial strains, have eased in recent months. It will be worth noting how she characterizes recent changes in financial conditions. Anything she says on the outlook for fiscal policy may also be important. In the FOMC minutes of the prior meeting, some participants showed concern that fiscal policy proposals might not be enacted or could have unexpected economic consequences amid increasing optimism among market participants. But we do not expect her comments and answers to point to a distinctly different path for policy from the one she just laid out.
Marketing communication : This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication.
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